Yen’s Weakness Persists Despite Fed Rate Cut, Defying Market Expectations

The U.S. Federal Reserve’s decision to cut interest rates for the first time in nine months has failed to reverse the persistent weakness of the Japanese yen, confounding widespread expectations. While the move was anticipated to narrow the interest rate gap between the U.S. and Japan and trigger a yen rally, the currency’s brief surge was short-lived, leaving investors to question the underlying forces at play.

At the Federal Open Market Committee (FOMC) meeting held from September 16-17, the Federal Reserve announced a 25-basis-point rate cut, a move largely predicted by markets. In response, the dollar-yen exchange rate momentarily strengthened to the mid-145 level. However, the yen’s gains quickly evaporated, with the rate returning to the familiar 147-yen territory by the following day. This rapid reversal suggests that the long-standing trend of a weak yen is far from over. According to Takashi Hiroki, Chief Strategist at Monex Securities, the market’s muted reaction is rooted in a more complex reality than a simple interest rate differential.

Beyond the Interest Rate Differential

A common view among market analysts has been that with the U.S. central bank easing its monetary policy while the Bank of Japan (BOJ) is expected to tighten, the shrinking rate differential would inevitably lead to a stronger yen. However, this perspective overlooks several critical factors.

First, markets are always forward-looking. While the divergent policy paths of the Fed and the BOJ are widely anticipated, traders are assessing the actual extent to which the interest rate gap can realistically shrink. Even with the recent 25bp cut, the U.S. federal funds rate stands at 4.00-4.25%, still significantly higher than Japan’s rates. With U.S. inflation not yet fully contained, the Fed’s ability to pursue a continuous series of rate cuts remains uncertain.

Furthermore, currency demand is not dictated by interest rates alone. As Mr. Hiroki explains, “Unlike stock prices, which can be valued based on academic theories like discounted cash flow, there is no definitive theoretical value for a currency’s exchange rate.” He notes that while interest rates are a key reference point, they are not always a reliable predictor. The Turkish lira serves as a cautionary tale: its exceptionally high interest rates of around 40% failed to prevent a massive currency depreciation, inflicting heavy losses on investors who were drawn in by the attractive yield. To profit from a high-interest-rate currency, one must hold it, but if the currency depreciates more than the interest gained, the investment results in a net loss.

The Bank of Japan’s Policy Dilemma

A core reason for the yen’s sustained weakness is the domestic economic landscape, which provides the Bank of Japan with little justification for aggressive rate hikes. While Japan’s headline Consumer Price Index (CPI) is running near 3%, a closer look reveals the inflation is not driven by broad-based, robust domestic demand.

The current inflation is largely a “cost-push” phenomenon, stemming from rising food prices and high import costs due to global inflation and a weaker yen. The “core-core” CPI, which excludes volatile fresh food and energy, shows a more subdued picture. When the effects of other processed food items—many impacted by import prices and domestic issues—are removed, the underlying inflation rate is merely 1.6%, falling short of the BOJ’s 2% target.

This type of inflation, caused by supply-side pressures rather than an overheating economy (known as “demand-pull” inflation), does not warrant contractionary monetary policy. Raising interest rates now would risk cooling the economy unnecessarily and could stifle the nascent recovery in wage growth, particularly for small and medium-sized enterprises. After three consecutive years of significant wage increases, momentum is already showing signs of fading, with corporate earnings forecast to decline for the first time in six years.

Structural Headwinds and Capital Outflows

With monetary policy an unsuitable tool for addressing the rising cost of living, the focus shifts to fiscal measures. Proposals for consumption tax cuts, subsidies for electricity and gas, and the removal of temporary gasoline taxes are gaining traction. However, such fiscal expansion raises concerns about Japan’s fiscal health, creating a second structural factor that weighs on the yen. Increased government spending could erode confidence in Japanese government bonds, leading to yen selling.

The third, and perhaps most significant, factor is a powerful and sustained outflow of Japanese capital. This includes not only government commitments, such as the $550 billion in loans and investments promised to the United States, but also a surge in private-sector activity. Major corporate actions, like Nippon Steel’s acquisition of U.S. Steel and SoftBank Group’s investments in American AI firms, require massive amounts of yen to be sold to acquire dollars.

Even household consumption patterns contribute to this trend. The growing “digital deficit”—payments made by Japanese consumers to U.S. tech giants like Google, Amazon, and Netflix, as well as subscription services like ChatGPT—has accumulated into a substantial source of consistent yen selling and dollar buying, further cementing the yen’s structural weakness.

Stock Market Rallies Amid Currency Woes

In contrast to the currency market, the Tokyo stock market has shown remarkable strength. The Nikkei 225 Stock Average closed at a new record high of 45,493, gaining 447 points. The rally was fueled by positive sentiment from U.S. markets, where the major indices also reached new highs. Investors believe the Fed’s willingness to cut rates will support a resilient U.S. economy, which benefits Japanese exporters.

Semiconductor-related stocks like Tokyo Electron and Lasertec saw significant gains, while reports of strong pre-orders for Apple’s new iPhone boosted shares of electronics components makers such as TDK. Meanwhile, the BOJ’s recent decision to begin selling its massive holdings of Exchange-Traded Funds (ETFs) had a limited market impact. “Although the timing was a surprise, the decision was largely seen as a carefully considered move designed to minimize disruption to the Japanese stock market,” said Masatoshi Kikuchi, Chief Equity Strategist at Mizuho Securities. With a disposal timeline that could stretch over a century, the market has concluded that the immediate effects will be negligible.