The Bank of Japan (BoJ) is set to raise interest rates to 0.75% this month, sending USD/JPY lower as the Japanese Yen (JPY) strengthens. Further BoJ hikes and stronger-than-expected Fed cuts could narrow the US-Japan rate gap to 150bps by year-end 2026, supporting additional yen gains, Commerzbank's FX analyst Michael Pfister notes.

Yen gains as market prices stronger Japanese rates

"Another Japanese interest rate hike is approaching. While the first signs that decision-makers were considering such a move at the December meeting emerged in September, the signals have intensified since then. Reports have emerged overnight that decision-makers are ready for the hike, provided there are no unexpected shocks before the meeting in just under two weeks. The Bank of Japan's intention to raise interest rates to 0.75% this month could hardly be clearer."

"If inflation remains above the central bank's target for such a long time, decision-makers risk losing credibility. I was also critical of the BoJ's interest rate hikes in 2024 because we simply did not see the 'second force' identified by the BoJ, i.e. sustained domestic inflationary pressure driven by services. However, a central bank cannot afford to ignore volatile components indefinitely. In recent decades, excessive inflation has not been an issue in Japan, so market participants are likely to tolerate a prolonged period of high inflation. But at some point, that will no longer be the case."

"The fact that the market is now pricing in stronger Japanese interest rate hikes is finally benefiting the yen – after many weeks of higher levels, USD/JPY is finally trending lower again. There is probably potential for even lower levels, i.e. a stronger yen. We expect another BoJ interest rate hike in April (to 1%), and anticipate stronger Fed interest rate cuts than the market expects. Ultimately, therefore, the interest rate differential is likely to fall to 150 basis points by the end of next year, with the yen appreciating accordingly against the US dollar."