Why the yen is set to strengthen – and why that matters
Normalising interest rates, among other factors, signpost a strengthening of the yen over the medium and longer term.
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After decades of ultra-low rates and a persistently weak currency, Japan’s macro backdrop is starting to shift. As the Bank of Japan (BOJ) gradually normalises policy, the implications extend well beyond the domestic economy. A move away from ultra-easy policy challenges the era of cheap yen funding: investors will have less incentive to borrow in yen and invest abroad. In turn, there are potential knock-on effects for global carry trades and diversification assumptions across asset classes.
In the near term, the yen remains under pressure, trading close to 160 against the dollar despite earlier intervention by the authorities. But the medium-term story looks more constructive: a combination of structural and cyclical forces is building that points to a stronger currency over time.
Rates normalisation has not strengthened the yen – for now
The BOJ is gradually raising interest rates after years of ultra-low and negative real interest rates, leading to a meaningful narrowing in the US–Japan rate differential (figure 1).
As Japanese yields rise and rate differentials narrow, the attractiveness of investing abroad begins to fade. Hedging costs increase, FX-adjusted returns on foreign assets fall, and some capital may start to be repatriated. A slowdown in these outflows should ultimately provide structural support for the yen.
Yet so far, a narrower rate gap has not translated into a stronger yen. Fiscal loosening and the crisis in the Middle East, among other factors, have helped keep the currency under pressure. That said, as real rates in Japan move further out of deeply negative territory, the fundamental case for yen strength continues to build (figure 2).
Figure 1: Yen hasn't woken up to narrowing rate differentials...
Figure 2: …but less negative rates favour a stronger yen
Source: LSEG Datastream, Schroders Economics Group, 18 June 2026
Fiscal risk is getting the way of higher rates supporting the yen
Following Prime Minister Sanae Takaichi's landslide election victory last year, fiscal policy has become looser. The government announced a record fiscal 2026 budget, with spending rising around 6% to over ¥122.3 trillion, the largest in Japan's history. This comes on top of the ¥18.3 trillion supplementary stimulus package passed in late 2025.
Importantly, looser fiscal policy is weakening the usual relationship between rate differentials and the currency. Typically, higher rates would support the yen by attracting capital and reducing incentives to invest abroad. But increased government spending is changing that dynamic. It has pushed up long-dated yields and steepened the curve, particularly at the ultra-long end, while also raising fiscal risk premia.
As a result, higher yields are not being driven purely by stronger fundamentals or tighter monetary policy. Instead, they partly reflect concerns about government borrowing and debt sustainability. That makes those higher yields less supportive for the currency and can even sustain capital outflows, rather than reversing them. As figure 3 shows, the yen has become less sensitive to the narrowing interest differential than in previous cycles.
Figure 3: Yen sensitivity to rate differentials has fallen as fiscal risk premium rises
Looking ahead, the recent ¥3 trillion supplementary budget to support household energy costs, alongside a proposed cut to the 8% consumption tax on food, worth around ¥5 trillion annually, would bring total measures to roughly ¥8 trillion. This is well below the ¥18.3 trillion stimulus package delivered in late 2025, pointing to a net fiscal tightening compared to last year.
Importantly, the authorities have been conscious of not funding new spending with increased debt issuance. The supplementary budget is expected to be financed by stronger tax and non-tax revenues.
Figure 4: Fiscal spending is expected to rise further this year
The key upside risk is a broader consumption tax cut, a costlier move that would add ¥15 trillion or more to the deficit, which could significantly widen the deficit and weigh on the yen. But this is not our base case. If fiscal concerns ease, rate differentials should reassert themselves as the key driver of the currency and that would be supportive of the yen.
At the same time, Japan's net debt-to-GDP has quietly been falling, with nominal growth outpacing borrowing costs. This is gradually reducing the fiscal risk premium, reinforcing the medium-term case for a stronger yen, although this tailwind may fade as rates rise further.
Improving terms of trade argue for a stronger yen
While the Middle East crisis and rising energy costs have weighed on Japan's terms of trade recently, the broader trend has been improving over the past few years (figure 5).
A key driver has been stronger export prices, supported by a shift towards higher-value sectors such as semiconductors, where firms have greater pricing power. This has more than offset higher import costs. At the same time, improved energy efficiency and the gradual restart of nuclear capacity have reduced reliance on imported fuel.
Japan’s terms of trade has been improving (Figure 5, left)... and the tech sector has lifted Japanese export prices (Figure 6, right)
A "BEER" (behavioural equilibrium exchange rate) model, which incorporates relative productivity between US and Japan, terms of trade, and trade openness suggests the yen is 15 to 20% undervalued. So fundamentals argue for a stronger currency.
Figure 7: Yen is undervalued based on macro fundamentals
Japan runs a persistent current account surplus, but it is less supportive of the currency than it appears. Much of it reflects primary income, returns on overseas assets, rather than actual flows back into yen. Nearly half consists of reinvested earnings retained by foreign subsidiaries that never return to Japan. While recorded in the statistics, these flows have little direct impact on the currency.
By contrast, the financial account shows persistent capital outflows. Institutional investors continue to allocate abroad, corporate FDI remains high, and the yen is still widely used as a funding currency. These flows involve active selling of yen, creating persistent downward pressure on the currency (Figure 8).
Figure 8: Reversal in capital flows would be supportive of the yen
For this dynamic to shift, real yields need to move into positive territory. This would reduce the incentive to borrow in yen and invest overseas. With the BOJ expected to continue to raise rates, our forecasts suggest real rates should exit negative territory toward the end of next year. But the process is likely to be gradual, with policymakers cautious of financial stability risks.
At the same time, US rates show little sign of falling, if anything, markets are now pricing the next Fed move as a hike. As a result, compression in the rate differential is likely to be modest and slow-moving.
On the investor side, rising JGB yields are beginning to make domestic bonds a more competitive alternative for life insurers and pension funds, particularly as FX hedging costs erode the yield advantage of foreign bonds. FX hedge ratios among life insurers are low, increasing the risk that a stronger yen triggers a wave of hedging, which could amplify the move.
Corporate FDI is the hardest channel to shift, reflecting deeper structural forces such as an ageing population and the long-standing move to produce closer to end markets. Government reshoring efforts may help at the margin, but a meaningful reversal would likely require a sustained period of yen undervaluation to restore domestic competitiveness. That said, even a moderation in these outflows would be supportive for the yen.
Conclusion
The medium-term case for a stronger yen is building and that matters for investors. Rate differentials have already narrowed meaningfully, terms of trade are improving, and the currency still looks undervalued. The main drags of fiscal loosening and persistent capital outflows also appear set to moderate.
If fiscal spending this year comes in below last year’s stimulus and real rates move back into positive territory, the incentives that have driven capital out of Japan begin to fade. That has implications not just for the FX, but for strategies built around yen funding, overseas allocation and diversification.
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