Why the Yen is Suddenly Waking Up

The Japanese yen is surprising the currency world with a sudden rally, despite interest rate and political headwinds. Elections, concerns about government debt, and signals from central banks point to an impending trend reversal.

The yen has been completely disrupting the currency market in recent days. The currency has been under pressure for some time due to the extremely low interest rates imposed by the Bank of Japan (BoJ). Two years ago, the policy rate was below zero, but it has now dropped to 0,75%. Despite the US interest rate falling from 5,5% to 3,75% during this period, holding assets in dollars is still considerably more lucrative than in yen. Many traders are borrowing money cheaply in Japan to invest at a higher return in countries such as the United States.

National debt in the spotlight
This carry trade has caused the yen to fall by 10% against the dollar since the spring of 2025. Over the past five years, this depreciation amounts to as much as 35%. Another factor putting pressure on the yen is political uncertainty. Prime Minister Sanae Takaichi has called snap elections. She hopes to gain a broader mandate at the February 8th polls, after the LDP, led by her predecessor Shigeru Ishiba, suffered a painful defeat at the end of 2024. Takaichi is galvanizing voters with plans to reduce VAT and reform the social security system. Currency traders are particularly concerned about the sky-high national debt, which threatens to increase even further as a result.

Oil on the fire
Against the interest rate and political headwinds, the yen soared by more than 2% against the dollar last Friday. This movement was likely fueled by the BoJ's support purchases. The central bank is reluctant to see a dollar rise above 160 yen. Meanwhile, the Federal Reserve toured major US banks to assess their yen holdings. This was interpreted in currency markets as a signal that the United States also wanted to push the dollar lower against the yen. Many traders had positioned themselves for a further decline in the Japanese currency. To prevent losses from mounting too quickly, a large portion of these positions were closed. This further fueled the yen rally.

Wake-up call for the yen
Support purchases are, of course, a somewhat shaky foundation for a structural recovery. But there's a good chance that the yen's freefall will gradually come to an end. Shortly after becoming party leader, Takaichi emphasized her commitment to a sound financial policy. Moreover, a large portion of Japanese government bonds is held by the BoJ, which can absorb any shocks. Rising inflation and the weak yen suggest that the policy rate will rise in 2026. The Federal Reserve, on the other hand, appears to be preparing for two interest rate cuts. With a narrowing interest rate gap and the ebbing of political risk after February 8th, the headwinds for the yen will clearly diminish. Last week's sudden rally is therefore a wake-up call that the currency could indeed choose a different direction.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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