Behind the JPY exchange rate volatility: Central bank rate hikes fall short of expectations, and the future policy direction becomes the focus

On December 19, the Bank of Japan announced a 25 basis point rate hike, raising the policy interest rate to 0.75%, marking the first time since 1995 that this level has been reached. However, unexpectedly, after this move, which was seen as a significant measure, the yen weakened instead of strengthening, and the USD/JPY exchange rate rose, with market sentiment not turning as expected.

Why Didn’t the Market Buy It?

Australian and New Zealand Banking Group strategist Felix Ryan pointed out that although the Bank of Japan has begun the rate hike process, the strength of the USD against the JPY reflects a core issue: the market remains uncertain about the pace and magnitude of future rate hikes by the central bank. This uncertainty has become the main reason for the yen’s softening.

Fidelity Investment Management strategist Masahiko Loo’s analysis is more straightforward — the market interpreted this rate hike as a dovish signal. Against the backdrop of a relatively loose Federal Reserve and supported by Japanese investors increasing their foreign exchange hedging ratios, a stronger dollar became inevitable. The institution maintains a medium-term target of 135-140 for USD/JPY.

How “Hawkish” Is the Central Bank’s Attitude?

Governor Ueda Kazuo’s comments at the press conference became a key point. He failed to provide a clear timetable for the next rate hike, only emphasizing that if economic and inflation prospects meet expectations, the rate hikes will continue. At the same time, he admitted difficulty in pre-determining the exact level of the neutral interest rate and plans to adjust the estimate (currently 1.0%-2.5%) when conditions allow.

It is this ambiguous language that disappointed the market. Nomura Securities pointed out that only when the central bank signals that the next rate hike could come earlier (for example, before April 2026) can it be considered a truly hawkish signal, triggering yen buying. Otherwise, without a significant upward revision of the neutral rate estimate, it will be difficult for the governor to convince the market that policy will ultimately tighten.

Outlook for Rate Hikes in 2026 and Beyond

Overnight index swap markets reflect expectations that the Bank of Japan may raise rates to 1.00% in the third quarter of 2026. Based on this forecast, ANZ Bank predicts that by the end of 2026, the USD/JPY exchange rate will rise to 153. This means that for a considerable period, the yen will remain relatively weak among G10 currencies, with interest rate differentials still unfavorable to the yen.

Overall, although the Bank of Japan has taken a step toward rate hikes, the lack of clear forward guidance means the market remains divided on the future direction of the yen. Whether the yen can escape its weakness depends crucially on when the central bank can provide a clearer policy path.