Policy Collision: Why Takaichi’s Fresh Mandate Raises the Risks for the Yen

The Bank of Japan’s Tightening Shift

At first glance, the policy backdrop looks supportive. The Bank of Japan is one of the few major central banks still leaning toward further tightening. In December it raised rates to 0.75% — modest by international standards, but Japan’s highest policy rate since 1995. After decades of deflation and ultra-loose policy, that shift is symbolically important. Furthermore, markets are pricing in additional hikes in 2026, with the next possibly as soon as April.

At the same time, other major central banks — including the Federal Reserve and the Bank of England — are expected to move in the opposite direction, cutting rates as labour markets start to deteriorate. In normal circumstances, narrowing interest rate differentials would provide a tailwind for the yen.

But the yen is not a normal currency.

The Carry Trade Risk Few Are Talking About

For years, it has been the funding currency of choice for the global “carry trade” — borrowing cheaply to deploy into higher-yielding assets abroad. That dynamic has been a structural weight on the currency. If Japanese rates continue to rise whilst global rates fall, that trade becomes less attractive. The risk is not just a gradual unwind, but a disorderly one.

A sharp reversal of the carry trade would not simply strengthen the yen. It could send tremors through global markets as Japanese investors repatriate capital, putting upward pressure on domestic yields while weighing on foreign bond markets and risk assets. The scale of this positioning is often underestimated. Any abrupt adjustment would have consequences well beyond Tokyo.

Fiscal Firepower — or Fiscal Fragility?

Yet monetary policy is only one side of the equation. The more immediate and arguably more profound risks to the yen lie in fiscal policy and politics.

Since taking office in October 2025, Prime Minister Sanae Takaichi has signalled a decisive shift. Her signature policy – a US$135bn fiscal stimulus package - aims to tackle weak growth and cushion households from rising living costs. Japan’s economy expanded just 1.1% in 2025 — hardly inspiring for a country seeking durable reflation.

But the challenge is not the intention, but the method.

Japan’s public debt already sits near 250% of GDP, by far the highest in the developed world. Among the most contentious measures included in the package is a two-year suspension of the consumption tax on food, costing an estimated US$32bn, alongside pledges for higher defence and infrastructure spending. Markets have been left asking a simple question: how will it be paid for?

That uncertainty has started to show up in the bond market. Yields on 40-year Japanese government bonds have risen above 4% for the first time on record, a striking move in a country long defined by ultra-low yields. Equity markets meanwhile have welcomed the prospect of stimulus, with Japanese stocks pushing to record highs. The yen and long-dated bonds, however, have not shared the enthusiasm.

The yen’s volatility spiked in January after PM Takaichi called a snap election to secure a fresh mandate for her program. This culminated in a so-called “rate check” on 23 January — conducted by Japanese authorities in coordination with the New York Federal Reserve — a step that typically precedes currency intervention. The move briefly stabilised the currency before it approached the psychologically important 160 per dollar level, a threshold that has triggered action in the past.

The takeaway was clear: markets are probing, and policymakers are watching closely.

The “Takaichi Trap”

Market unease is centred on the risk that some have dubbed the “Takaichi trap”: fiscal expansion running headlong into monetary tightening. If the government loosens policy while the Bank of Japan tightens to contain inflation, higher interest costs could offset much of the stimulus. Growth may fail to accelerate meaningfully, debt servicing costs would rise, and the yen could weaken further — exacerbating the very cost-of-living pressures the stimulus was designed to relieve.

Currency markets are highly sensitive to this kind of policy incoherence. A credible path to productivity-enhancing investment could reassure investors. Vague promises of future efficiency gains will not.

Geopolitics and External Pressures

here are also external fault lines to consider.

Japan remains a significant net importer of energy. Elevated oil and gas prices, shaped by geopolitical events far beyond Tokyo’s control, directly worsen its trade balance. A weak yen compounds that pressure by inflating the cost of imports, squeezing households and corporates alike.

Relations with China add another layer of complexity. Robust rhetoric from PM Takaichi over Taiwan has raised tensions with Beijing, Japan’s largest trading partner. Any deterioration in trade relations would be felt quickly in export volumes and business confidence, both critical pillars for the yen.

Meanwhile, Japan’s relationship with the United States remains pivotal. For now, PM Takaichi appears to have found a fan in President Trump, and even secured an endorsement in the run up to the election. Yet, a weak yen and persistent trade surplus could once again draw scrutiny from Washington, ending the honeymoon period.

What Markets Should Be Watching

In short, the yen sits at the intersection of tightening monetary policy, expansive fiscal ambition, structural carry trade positioning, debt concerns, and geopolitical uncertainty. Any one of these factors would be manageable in isolation. Together, they create a fragile balancing act.

For investors and corporates alike, the coming months will hinge on three key questions:

• Can the Bank of Japan normalise policy without destabilising bond markets?

• Will fiscal stimulus translate into sustainable productivity gains, or simply higher debt?

• Does the global environment, from energy prices to geopolitics, turn from headwind to shock?

The yen’s weakness is not simply a function of interest rate differentials. It reflects deeper concerns about policy alignment, debt sustainability and Japan’s place in an increasingly fractured global economy.

That is why, despite the prospect of further rate hikes, the risks around the currency remain skewed to the downside, and why careful navigation of these cross-currents will be essential in the months ahead.