Japan amid monetary and fiscal shift – will the yen regain strength?

• BOJ may raise interest rates further, signaling a historic move away from decades of zero and negative rates and potentially strengthening the yen.
• Japan’s government introduces a controlled fiscal stimulus package while trying to maintain credibility and avoid panic-level debt expansion.
• Geopolitical tensions with China and shifting Fed policy could significantly influence capital flows, risk sentiment, and the yen’s future trajectory.

The Japanese economy is entering a period of heightened uncertainty, yet at the same time a potential historic turning point in monetary and fiscal policy. Market attention is currently focused on the Bank of Japan (BOJ), which is gradually moving away from its ultra-low interest rate policy. Meanwhile, the government in Tokyo is implementing the largest stimulus measures in years, and the geopolitical situation in the region is becoming increasingly tense. All of these factors may, in the coming quarters, shift the yen’s status from one of the weakest currencies in the world to an asset once again sought after by investors.

BOJ in the spotlight – market pricing in a shift

The Bank of Japan currently maintains interest rates at 0.5%, the highest level in over 30 years. This marks a symbolic departure from the era of zero and negative interest rates that defined Japan’s monetary policy for decades. Expectations are increasingly building that BOJ’s December meeting could result in another rate hike, particularly in light of bond market data.

Bond market signals stress

The latest auction of 2-year government bonds revealed mounting tensions in the short-term debt segment. Demand was weaker than usual (bid-to-cover of 3.53 versus the average of 3.66), and the difference between the highest accepted and the average price rose to 0.012 (compared to 0.002 a month earlier). The yield on 2-year bonds reached 0.975%, the highest since 2008. This is a clear signal that the market is reluctant to engage in low-yield securities given the possibility of further rate hikes.

Fiscal stimulus, but “controlled”

In parallel, Prime Minister Sanae Takaichi’s government approved an additional fiscal package worth 18.3 trillion yen. The funds are intended for households and increased military spending. The program is financed mainly through short-term debt – the issuance of 2- and 5-year bonds will increase by 300 billion JPY, and treasury bills by 6.3 trillion JPY. Additionally, higher-than-expected tax revenue and unspent funds from the previous year will be used.

Although short-term debt will rise nominally, total debt issuance for the 2025/26 fiscal year will fall to 40.3 trillion JPY from 42.1 trillion the year before. The government aims to demonstrate that it is conducting responsible fiscal policy, avoiding a return to pandemic-era excess.

Geopolitical factors Increase risk aversion

Japan’s economy, however, may encounter external obstacles. Deteriorating relations with China – especially in the context of Prime Minister Takaichi’s remarks about readiness to respond militarily in the event of aggression toward Taiwan – are raising serious investor concerns. Goldman Sachs estimates that a decline in tourism from China could lower GDP growth by 0.2 percentage points, while restrictions on the export of consumer goods could reduce it by another 0.1 percentage points. A potential escalation of sanctions could have a much larger and difficult-to-quantify impact.

Yen in retreat – but for how long?

In the last quarter, the yen weakened by 5.6% against the dollar, becoming the weakest currency among the G10. The prevailing narratives in the market are expectations that the BOJ will refrain from raising rates and that Japan will lose control over its public debt. However, both of these assumptions are beginning to lose relevance.

Morgan Stanley strategists estimate that the USD/JPY rate around 157 is clearly overstated relative to fundamentals. Their base scenario assumes the pair falling to 140 in Q1 2026, followed by a rebound toward 147 by the end of the year. Key factors are expected to be Fed rate cuts and falling U.S. bond yields, which would weaken the dollar and trigger capital outflows from the U.S.

Three scenarios for the Yen:

• BOJ rate hike in December:
  The yen strengthens, yields rise, and the carry-trade strategy becomes less attractive. USD/JPY may fall toward 152.
  
• BOJ remains passive:
  The yen weakens again, and USD/JPY may rise to 158–160. The risk of currency intervention by authorities increases.
  
• The Fed decides on another rate cut:
  The dollar weakens, investors withdraw from U.S. bonds, and the yen gains as a safe-haven currency. USD/JPY may drop to around 140–145.

Yen at a Critical Turning Point?

Japan is at an inflection point in both monetary and fiscal policy. For the first time in decades, the Bank of Japan is seriously considering rate hikes, while the government is stimulating the economy in a controlled manner, avoiding signals of fiscal panic. Meanwhile, geopolitical tensions and changing Fed sentiment in the U.S. are creating a new reality for investors.

All of this may cause the yen – recently marginalized and weak – to become once again a sought-after currency among global market participants. The key issue, however, will be whether the BOJ decides to send a clear signal of monetary policy normalization before the Fed does – otherwise, Japan may miss the moment to regain investor confidence.