Japanese Yen Approaches 40-Year Low: Bank of Japan Has Raised Rates to 1%, So Why Can’t It Stem the Decline?

Original Source: Wall Street Sights

During Asian trading on June 23, the dollar traded around 161.57 against the yen, just shy of the 161.81 level hit last week – the yen's weakest point since December 1986.

And this came just a week after the Bank of Japan raised its policy rate to 1% – the highest level in 31 years.

In other words: The BOJ did the most hawkish thing within its power, and not only did the yen fail to rally, but it weakened further.

Finance Minister Katsunobu Kato was so alarmed that he directly called US Treasury Secretary Scott Bessent to discuss exchange rates. Japan spent a record 11.7 trillion yen (approximately $73.7 billion) intervening in the currency market in May. The market is now eyeing 161.96 – the previous "defense line" from July 2024. Once breached, the next target is the 162.25 level from December 1986.

But the truly dangerous signal isn't the price itself; it's that this time, both defenses – rate hikes and intervention – have failed simultaneously.

1% Interest Rate, 350bp Spread

The Bank of Japan raised its policy rate from 0.75% to 1% on June 16, with a vote of 7 to 1 – only one member opposed. This marked the fifth rate hike since the start of the tightening cycle in March 2024 and the first time Japan's interest rate has touched the 1% threshold since 1995.

If you only look at the BOJ's actions themselves, what it's doing is already quite aggressive. From -0.1% to 1%, a net increase of 110 basis points in 22 months.

But the problem is: You're raising rates, but so is everyone else, and at a much faster pace.

The US federal funds rate is currently in the 3.50-3.75% range. The Fed kept it unchanged at its June meeting – but the story behind it is far more dangerous than it appears.

The Fed's June dot plot showed that 18 of the 19 FOMC participants submitted projections, with 9 expecting further rate hikes in 2026. The specifics: 5 predicted two more hikes (25bp each), 1 predicted three more, and 3 predicted one. The median year-end rate jumped from 3.4% in March to 3.8% – the largest single upward revision since the dot plot was introduced in 2012. US CPI hit a three-year high of 4.2% in May, while core PCE remained stuck near 3% year-over-year.

Let's do the math: US rate at 3.63%, Japan rate at 1.00%. The nominal interest rate spread is 263 basis points.

But the long-end spread is even starker: The 10-year US Treasury yield is around 4.45%, while the 10-year Japanese government bond yield is about 2.65% – a gap of roughly 180 basis points.

Add to that the fact that the BOJ is continuing its bond purchases (though reducing them by 200 billion yen per quarter, it won't completely stop buying until April 2027), which artificially caps the upside for JGB yields. This means the annualized interest rate differential return for carry trades (borrowing yen, buying US bonds) remains attractive – roughly 263bp on the short end and 180bp on the long end. The BOJ's bond-buying operations artificially suppress JGB yields, and market pricing implies no further rate hikes by the BOJ this year, making the carry trade's interest rate foundation seemingly solid.

But the critical risk isn't whether the BOJ will implement a "massive rate hike." The destructive power of carry trades has never been about small changes in interest rates; it's about the stampede-like unwinding triggered by crowded positions combined with unexpected catalysts. The August 2024 episode is a case in point: The BOJ raised rates by just 15bp to 0.25%, and combined with weaker-than-expected US employment data, it triggered a chain reaction where the Nikkei plunged 12% in a single day and USD/JPY fell sharply from 156 to 141. In its post-mortem report, the BIS accurately characterized carry trades as "picking up pennies in front of a steamroller": accumulating steady returns during low-volatility periods, only to incur massive losses instantly when tail risks materialize. With today's spreads being wider than back then, positions are only more crowded.

Tai Hui, Chief APAC Market Strategist at JPMorgan Asset Management, put it more bluntly: "The rate hike itself was within expectations. What was truly surprising was the overwhelming 7-to-1 support – it shows the committee is more worried about inflation than growth."

Reading between the lines: There's a consensus forming within the BOJ – 1% is not enough. But the market doesn't believe it will dare to keep raising.

The 11.7 Trillion Yen 'Brake Pad'

If rate hikes can't stop the yen's fall, then just buy yen directly.

Official data released by Japan's Ministry of Finance on May 29 showed that between April 28 and May 27, Japanese authorities spent a total of 11.735 trillion yen (about $73.7 billion) intervening in the currency market, setting a new record for monthly intervention scale.

The largest single-day action occurred on April 30 (just before Japan's Golden Week): The yen was pulled sharply from 160.72 to 155.50, a daily fluctuation of over 3%, reversing about 5 yen. Additional operations occurred in early May, with total estimated scale around 9.5-10 trillion yen.

This marks the third consecutive year Japan has deployed large-scale intervention:

April-May 2024: 9.79 trillion yen (about $62.3 billion), triggered at 160.25

July 2024: 5.53 trillion yen (about $36.8 billion), triggered at 161.76

April-May 2026: 11.74 trillion yen (about $73.7 billion), triggered at 160.72

Total over three years: Over 27 trillion yen, nearly $180 billion.

But what about the effect? It's the same every time: a short-term reversal of 3-5 yen, followed by a return to pre-intervention levels within 4 to 8 weeks.

Jesper Koll, Expert Director at Monex Group, has a vivid analogy: "Intervening in the exchange rate without changing domestic monetary policy is like pressing the brake while keeping your right foot slammed on the accelerator – at best, the passengers get a little jolt; at worst, the brake pads burn out completely."

This is the moment the "brake pads are burning out."

Compare this to the 1985 Plaza Accord – where the G5 acted in concert, coordinating policy, interest rates, and fiscal measures, pushing the yen from 240 to 200, achieving a permanent trend reversal of about 17%. Today, Japan is fighting a unilateral battle. US Treasury Secretary Bessent simply "took the call," with no indication of coordinated action.

Warsh's Silence: More Fearsome Than a Rate Hike

One faint hope the market held for the yen was that the Fed might cut rates due to economic weakness, thereby narrowing the US-Japan interest rate differential.

The June Fed meeting completely extinguished that hope.

Fed Chairman Kevin Warsh did two significant things:

First, he refused to submit a dot plot projection. This is the first Fed chair since the dot plot's introduction in 2012 to not submit a personal forecast. Warsh had publicly criticized the dot plot for creating a "false sense of precision" before his appointment. But the timing of his silence at the June meeting was particularly telling – coinciding with inflation surging to 4.2% and deep divisions within the committee. The market cannot "position" this chair anywhere on the hawkish-dovish spectrum, and the uncertainty itself creates pressure.

Second, the meeting statement removed the previous language hinting that the "next move would be a rate cut." Combined with 9 hawkish dots and the median rising to 3.8%, this is equivalent to saying, "We aren't raising rates this time, but a rate hike is now on the table for the next move."

Market pricing reflects this anxiety: The CME FedWatch shows a 8.8% probability of a rate hike in July, rising to 34.4% in September, and nearly 50% by October. By year-end, the implied rate priced by the market is around 3.95%.

In other words: The current US rate of 3.63% is not only unlikely to fall, but there's about a one-in-three chance it could rise above 4% by year-end.

This means the US-Japan interest rate differential is not only unlikely to narrow but could even widen further.

Japan's Own Inflation Ledger

A common counterargument is that a weaker yen benefits Japanese exports, and the Japanese government might actually welcome it.

This argument might have held before 2022. But Japan in 2026 is no longer that deflationary economy.

Japan's Producer Price Index (PPI) rose 6.3% year-on-year in May, the fastest pace in over three years, driven primarily by surging energy costs. Although core CPI fell back to 1.4% in April (suppressed by government policies like gasoline tax cuts and free high school tuition), the BOJ clearly stated in its June statement: "Cost pass-through from rising crude oil prices is proceeding relatively quickly in B2B transactions and may spread to broader consumer price increases."

Behind this is the oil price shock from the Iran conflict. Although US-Iran negotiations made progress on June 22 (the US announced a 60-day waiver for Iranian oil exports), causing Brent crude to briefly dip below $77 – the situation in the Strait of Hormuz is far from truly stable.

For Japan, rising import energy costs directly push up domestic costs, and the yen's depreciation amplifies import prices. The government of Prime Minister Sanae Takaichi has allocated a 3 trillion yen supplementary budget to subsidize household energy costs, but fiscal space is not unlimited.

A more profound issue is the contradiction between Japan's staggering government debt stock and interest rate levels.

Japan's government debt is approximately 1,250 trillion yen (over 250% of GDP). If interest rates continue to rise from 1%, interest payments alone could devour the fiscal budget. According to MOF estimates, for every 1 percentage point increase in interest rates, the government's annual interest payment burden would increase by about 3.7 trillion yen.

This is the BOJ's dilemma: Don't raise rates, and the yen continues to fall, worsening imported inflation. Raise rates, and the government's debt interest payments skyrocket, threatening fiscal sustainability.

Next Steps: Three Variables Determine the Direction

Whether the yen can stop its decline does not depend on what Japan does unilaterally – both the rate hike and intervention paths have reached their limits. The real variables lie outside Tokyo.

Variable 1: Will the Fed actually raise rates again?

This is the most critical variable. Current market pricing shows only an 8.8% probability of a July rate hike, but it has already risen to 34% for September and nearly 50% for October. If US CPI and core PCE continue to surprise to the upside over the next two months – the June SEP already sharply revised up the 2026 PCE forecast from 2.7% to 3.6% – the probability of a September rate hike could quickly move towards 50% or higher. At that point, the US-Japan nominal spread would approach 300bp, and the yen would likely break through 162.25, entering uncharted territory not seen since 1986. Without a Plaza Accord or G5 coordination, the next vague technical reference point doesn't appear until around 165.

Variable 2: The actual implementation of the US-Iran agreement.

On June 22, the US announced a 60-day waiver for Iranian oil exports, providing a rare window for de-escalation in the Strait of Hormuz, with Brent crude briefly falling below $77. If a final agreement is reached before August, it would significantly alleviate Japan's imported inflation pressure as a net energy importer. Falling oil prices would directly narrow Japan's trade deficit, providing structural support for the yen – this is the most favorable scenario for the yen among the three. However, geopolitical negotiations are inherently volatile, so this should not be assumed as a base case.

Variable 3: The BOJ's stance at its July meeting.

Following the June rate hike to 1%, market pricing already implies no further rate hikes this year – a core premise for the yen's weakness. However, against the backdrop of PPI at 6.3% year-on-year, if the July statement includes language suggesting "further adjustments to the degree of monetary easing are necessary," even without immediate action, it could marginally change the profit-and-loss calculation for carry trades. However, Governor Kazuo Ueda has not yet spoken publicly since missing the June meeting (due to hospitalization), creating uncertainty about the policy signals from the July meeting.

Conclusion

The yen's story has never been just about exchange rates.

It encapsulates Japan's survival dilemma in the era of Globalization 3.0: an aging, highly indebted economy dependent on energy imports, whose monetary policy autonomy has been completely hijacked by the US interest rate cycle.

The BOJ raised rates to a 31-year high – not enough. Japan's Ministry of Finance spent $180 billion – not enough. The Finance Minister called Washington – the other side answered politely but nothing more.

In 1986, the yen weakened to its limit at 162 before appreciating significantly in the aftermath of the Plaza Accord. That year, Japan was still the world's second-largest economy, challenging for the top spot.

In 2026, the yen is back near 162. But this time, there is no Plaza Accord, no G5 coordination. Only Japan is pressing its own brakes – while the accelerator is firmly under Washington's foot.