USD/JPY in Focus Ahead of Key Central Bank Decisions

Key Points

• USD/JPY reversed sharply after breaking above 157 in late November, pulling back below 156.00 as traders priced in a December Fed cut and the potential for a hawkish decision by the Bank of Japan (BOJ).
• The core engine of the yen carry trade—wide interest rate spreads—has weakened, with the 10-year U.S.–Japan yield gap falling from 350bps to near 220bps.
• Against that backdrop, volatility in the forex market could rise in the coming weeks as traders position around the December 9–10 Federal Reserve meeting and the BOJ’s December 18–19 decision.
• Some strategists, including Morgan Stanley, have called for further yen strength—potentially pushing the USD/JPY exchange rate toward 140 by early 2026. But future moves will undoubtedly hinge on what unfolds in the weeks ahead.

With the calendar shifting to December, the yen has found new strength against the U.S. dollar—reversing a months-long stretch of weakness that ran from summer through mid-November.

During that time, USD/JPY climbed steadily, fueled by markets that continued to favor the dollar despite Japan’s slow but consistent march toward policy normalization. That rally peaked around November 20, when USD/JPY briefly broke above 157—the highest level since early January.

But the momentum didn’t hold. As traders priced in a likely Fed rate cut at the upcoming December 9–10 meeting, and absorbed increasingly hawkish signals from the Bank of Japan (BOJ), sentiment shifted. Today, USD/JPY sits closer to 155.50—a meaningful pullback that suggests the tide may be turning.

Behind that reversal lies a deeper change in perception—especially around the Bank of Japan’s policy trajectory.

For most of 2025, the Bank of Japan struck a deliberately cautious tone—acknowledging rising inflation and early signs of wage momentum, while carefully avoiding firm commitments on rate policy. That restraint kept expectations low. Even as Japan’s economic data improved, the messaging was widely viewed as exploratory rather than actionable.

Of late, however, that perception has changed.

In recent weeks, the central bank’s tone has grown more direct, reflecting a macro backdrop of stable inflation and increasingly durable wage growth. What once felt like academic framing has seemingly transformed into forward guidance. Governor Ueda and other officials are no longer hedging—they’re preparing. With the next Bank of Japan meeting scheduled for December 18-19, a rate hike is now viewed as a real possibility in December or early 2026.

Meanwhile, the Federal Reserve is tilting in the opposite direction. Futures markets are now pricing in an 85% chance of a quarter-point cut at the December meeting. With the BOJ’s rhetoric firming and the Fed easing, the balance in USD/JPY has begun to shift. That shift in sentiment has validated early contrarians—particularly those who argued the dollar’s strength against the yen wouldn’t last.

Strategists at Morgan Stanley, for example, recently called USD/JPY overvalued and projected a sustained reversal, driven by a series of Fed cuts and a more assertive Bank of Japan. In their base case, the USD/JPY exchange rate drops toward 140 by early 2026, before rebounding modestly as carry trade dynamics reassert themselves.

That’s what makes the current moment so pivotal. As central bank monetary policy realigns, the mechanics of the carry trade—one of the most powerful structural forces in the global financial markets—are back in focus.

The Mechanics Behind the Yen Carry Trade

1. Borrow yen in Japan, where rates are near zero
2. Convert those yen into a currency with a higher yield, like the US dollar
3. Use that money to buy higher yielding assets such as US treasuries, bonds, equities, or even crypto
4. In theory, you are able to pocket the difference between the higher return and low cost of borrowing

For decades, the yen carry trade has been a quiet engine behind capital flows. Its mechanics are simple: borrow in yen—thanks to Japan’s chronically low interest rates—and redeploy those funds into higher-yielding assets abroad. As long as volatility stays contained and the yen remains weak, the trade works. But the environment supporting it is no longer as stable as it once was.

At the heart of the strategy is interest rate arbitrage.

For years, the Bank of Japan kept policy deeply accommodative while other central banks gradually tightened. That divergence gave traders a persistent edge: fund positions with ultra-cheap yen, and earn the spread in U.S. credit, emerging-market debt, global equities, or even crypto. With Japan’s overnight rate near zero and U.S. yields north of 5%, it was one of the most reliable trades in macro.

But the landscape has shifted.

Since mid-2025, Japanese yields have climbed sharply—driven by rising inflation expectations, fiscal stimulus, and a more hawkish tone from the Bank of Japan. As a result, the U.S.–Japan 10-year yield spread has narrowed from nearly 350 basis points to around 220, chipping away at the core advantage of the yen carry trade.

That shift adds fragility to a system built on stability. The risk isn’t just diminished returns—it’s a disorderly unwind. If the yen strengthens meaningfully (and suddenly), carry positions can reverse quickly. Traders who borrowed in yen may be forced to buy it back, accelerating currency appreciation and triggering broader liquidation. It’s a reflexive loop that can spill across markets—tightening liquidity and amplifying volatility well beyond the forex market.

In periods of global stress, the yen has a well-documented habit of flipping from passive funding tool to active safe haven. When that reversal begins, the unwind can be anything but orderly. Risk assets come under pressure. Cross-asset correlations fracture. As the chart below illustrates, sharp gains in the yen have often coincided with sudden equity market drawdowns—a reflection of how deeply yen-based leverage runs through global portfolios.

Importantly, the current setup doesn’t guarantee an unwind of the carry trade. If the BOJ tightens cautiously, and the Fed moves incrementally in the other direction, markets may have room to recalibrate.

But the conditions that once made the yen carry trade feel like a one-way bet are beginning to fray. In a macro environment where policy is diverging and volatility is rising, what was once a background dynamic is quickly becoming a focal point.

What Comes Next for USD/JPY

Having mapped the trajectory of USD/JPY and the structural forces powering the yen carry trade, the focus now shifts to what comes next—and how durable this regime really is.

Markets expect the Federal Reserve to ease at its December 9–10 meeting, while also assigning meaningful odds to a Bank of Japan rate hike at its December 17–18 gathering. That setup has pulled USD/JPY off its recent peak above 157 toward roughly 155.5—a sentiment shift, but not necessarily a trend change. At least not yet.

Still, even modest moves in the U.S.–Japan rate differential can have outsized effects. If both central banks act as expected, the yen could strengthen further, forcing some carry traders to unwind leveraged positions. In thin year-end liquidity, that kind of repositioning can snowball, potentially dragging USD/JPY back toward the 150 area.

But the opposite scenario remains firmly in play. If the Bank of Japan hesitates—or signals only incremental tightening—the dollar could recover, pushing USD/JPY back toward the intervention-sensitive 157–160 zone.

All told, that means the carry trade is still supported, but less comfortably than before.

That fragility is becoming harder to ignore. The U.S.–Japan yield spread has continued to narrow, as Bank of Japan tightening moves from possibility to probability and rising fiscal concerns begin to steepen Japan’s domestic yield curve. Taken together, these shifts point to a more delicate equilibrium—one where a sharper-than-expected BOJ move, a wave of global risk-off, or a sudden reversal in dollar sentiment could spark a faster, more disorderly unwind of carry trades than many traders anticipate.

Put simply, the status quo is under pressure. With pivotal policy decisions on the horizon, the outlook for USD/JPY appears increasingly binary: either central banks reinforce the pair’s elevated range, or markets are forced to recalibrate. Until then, the key levers remain in play—the Federal Reserve, the Bank of Japan, the recent yen rebound, and the quiet but widening cracks beneath a carry trade that still dominates the landscape… until it doesn’t.

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