Japanese Yen 2026: Why the JPY Decline Matters Far Beyond Japan’s Borders

Japanese yen intervention can slow the decline, but not reverse it

Bondford examines why the Japanese yen has fallen to a near forty-year low against the US dollar, why the Bank of Japan faces an increasingly difficult policy dilemma, and what a potential unwinding of the yen carry trade could mean for global financial markets in 2026.

While markets remain fixated on the US dollar and the ongoing conflict in the Middle East, another story risks slipping under the radar. At the end of June, the Japanese yen weakened to around JPY162 against the US dollar, its lowest level in almost forty years. More worrying still, policymakers appear to be running out of effective ways to halt its decline. That matters not only for Japan, but for the global economy, where decades of ultra-low Japanese interest rates have helped shape international capital flows.

Since 2022, Japan's Ministry of Finance has spent well over US$200 billion intervening in foreign exchange markets to support the yen. Yet these interventions have provided only temporary relief before the currency resumed its decline. The reason is simple: intervention can smooth volatility for a few days or weeks, but it cannot overcome the much larger forces driving the yen lower. Unless those underlying fundamentals change, markets have tended to view every intervention as a buying opportunity for the dollar rather than a turning point for the yen.

The Bank of Japan's policy trap: no easy escape

The biggest of those fundamentals is the yawning interest rate gap between Japan and the rest of the developed world. While central banks elsewhere aggressively tightened monetary policy to tackle inflation once the scale of the problem became apparent in 2022, the Bank of Japan has moved only cautiously away from decades of ultra-loose policy. Interest rates only returned to positive territory in 2024, and the latest 25 basis point increase in June lifted the policy rate to just 1% – the highest level in Japan for three decades, but still a fraction of US rates, which remain between 3.5% and 3.75%. With inflationary pressures in the US showing little sign of disappearing, that gap could persist for some time.

The result is a powerful incentive for investors to move capital out of Japan in search of higher returns overseas. This is not simply the work of currency speculators. Japanese pension funds, insurers and asset managers have spent years allocating vast sums abroad because domestic returns have been so low. Those structural capital outflows have become an enduring source of downward pressure on the yen.

Japan therefore finds itself caught in an increasingly uncomfortable policy dilemma. Raising interest rates would make yen-denominated assets more attractive, helping to strengthen the currency and reduce imported inflation. Yet it would also increase borrowing costs across an economy that has become accustomed to near-zero interest rates after decades of stagnation. Leaving rates low, meanwhile, supports economic activity and keeps government borrowing affordable, but risks further weakening the currency and fuelling inflation through more expensive imports. Foreign exchange intervention can buy time, but it cannot resolve this fundamental trade-off.

The cost of defending the Japanese yen

The challenge is made even more difficult by fiscal policy. Prime Minister Sanae Takaichi has unveiled a multi-year spending programme worth around US$2.3 trillion in an effort to stimulate growth and strengthen Japan's long-term economic prospects. Yet this risks working directly against the Bank of Japan's gradual efforts to normalise monetary policy. Expansionary fiscal policy supports demand at the very moment monetary policy is attempting to restrain inflation, potentially forcing the Bank of Japan to raise interest rates further than it otherwise would. Fiscal and monetary policy risk cancelling out part of each other's impact, leaving both less effective.

This creates another problem. Japan's public debt exceeds 200% of GDP, by far the highest among advanced economies. Such debt has remained manageable largely because interest rates have hovered around zero for decades. That environment is beginning to change. Ten-year Japanese government bond yields have climbed to around 3%, their highest level in roughly thirty years. Every additional increase in interest rates raises the government's borrowing costs, making it increasingly difficult to balance supporting the currency with maintaining fiscal sustainability. The very medicine needed to strengthen the yen risks making Japan's debt burden significantly harder to manage.

External events have added further pressure. Japan imports around 90% of its energy requirements, leaving the economy particularly exposed to rising oil and gas prices. Continued instability in the Middle East therefore presents a double challenge, increasing inflation while worsening Japan's import bill. A weaker yen amplifies those higher energy costs still further, creating a vicious cycle in which currency weakness itself contributes to additional inflationary pressures.

Could the yen carry trade finally unwind?

All of this raises an even bigger question for global financial markets: what happens if the era of ultra-cheap Japanese money finally comes to an end?

The risk is that these positions can unwind far more quickly than they are built. If Japanese interest rates were to rise materially, or if the yen strengthened sharply, investors could suddenly find those trades far less profitable. Borrowers would rush to repay yen loans, selling overseas assets in the process and buying back the Japanese currency. That could trigger a self-reinforcing cycle of further yen appreciation and additional asset sales, sending shockwaves through global financial markets.

For now, such a scenario remains a risk rather than a forecast. However, it illustrates why the yen deserves more attention than it currently receives. The question is no longer simply whether Japan can defend its currency. It is whether the economic model that has underpinned global capital flows for much of the past three decades is beginning to change. If it is, the consequences will extend far beyond Tokyo's foreign exchange market.

This commentary reflects Bondford’s views and should not be construed as representing the views of the author’s employer or any other affiliated organisation.