Behind the Yen's Volatile Fluctuations: Central Bank Hikes Rates but Fails to Meet Market Hawkish Expectations

After the Bank of Japan’s decision on December 19, the financial markets experienced a misalignment in expectations management. The central bank raised interest rates as expected by 25 basis points, bringing the policy rate to 0.75%, the highest level since 1995. However, this decision did not strengthen the yen as the market anticipated; instead, the US dollar against the yen showed signs of strengthening.

Ambiguous Signals from the Central Bank’s Rate Hike Decision

Governor Ueda stated in the announcement that if the economic and price outlooks develop as expected, the rate hike process will continue. However, at the subsequent press conference, he deliberately kept the timing of the next rate hike vague, failing to provide the clear guidance the market was hoping for. Particularly regarding the neutral interest rate level, the central bank only maintained a broad estimate of 1.0%–2.5% and said it would adjust at an appropriate time.

This cautious stance has led the market to doubt the Bank of Japan’s resolve to raise rates. Felix Ryan, strategist at ANZ Bank, pointed out that although the rate hike has begun, the strengthening of the US dollar against the yen reflects market expectations that the central bank’s subsequent rate hikes may lack momentum. The bank forecasts that by the end of 2026, the USD/JPY exchange rate will reach 153.

Multiple Factors Suppress the Yen’s Performance

The yen weakened despite the rate hike, due to multiple reasons. Masahiko Loo, strategist at State Street Global Advisors, analyzed that the Federal Reserve’s relatively accommodative policy stance contrasts sharply with the Bank of Japan’s rate hikes, making the interest rate differential unfavorable for the yen. Additionally, Japanese institutional investors increasing their foreign exchange hedging ratios from historic lows have also supported the US dollar’s strength.

The firm maintains a medium-term target of 135–140 for USD/JPY, indicating that even considering the central bank’s rate hike progress, there is little short-term prospect for significant yen appreciation.

Market Expectations vs. Reality

According to overnight index swap data, the market currently expects the Bank of Japan to raise rates to 1.00% by Q3 2026. Nomura Securities pointed out that only when the central bank signals that the next rate hike could occur earlier than expected (for example, before April 2026) will the market view it as a hawkish stance, triggering yen buying.

In other words, Governor Ueda’s conservative language in this decision is actually interpreted by the market as a somewhat dovish posture. With only modest upward revisions to the neutral rate estimate, it seems increasingly difficult for the central bank governor to convince the market that the terminal rate will rise further.

Yen Trend Outlook

Looking ahead, the yen’s movement will depend on the central bank’s future communication strategy and actual rate hike progress. If the BOJ can provide a clearer rate hike roadmap by 2026, the yen may reverse its relative weakness. Otherwise, under continued unfavorable interest rate differentials, the yen will likely continue to underperform among G10 currencies.