The Japanese yen has once again become one of the world's most closely watched currencies. Having fallen to levels against the US dollar not seen since the 1980s, it has fuelled fresh speculation that Japanese authorities are preparing to step into the foreign exchange market. Intervention can certainly influence sentiment and slow a sharp move, but history shows it is rarely enough to reverse a trend driven by powerful economic forces. To understand why, it is worth looking beyond the headlines.

The Forces Driving Yen Weakness

The biggest factor behind the yen's decline is the wide gap between interest rates in the United States and Japan. Although the Bank of Japan has started moving away from its long-standing ultra-loose monetary policy, Japanese interest rates remain far below those in the US. At the same time, resilient US economic growth and stubborn inflation have strengthened expectations that American interest rates will stay higher for longer.

For investors, the result is straightforward. US assets offer more attractive returns, encouraging money to flow out of Japan and into dollar-denominated investments. Those capital flows boost demand for the US dollar while placing persistent downward pressure on the yen.

The interest-rate gap also fuels one of the most influential strategies in global financial markets, the carry trade. Investors borrow cheaply in yen before investing the proceeds in higher-yielding assets elsewhere, profiting from the difference in interest rates as long as exchange-rate movements remain manageable. Every time investors sell borrowed yen to buy foreign assets, additional pressure is placed on the Japanese currency. While the carry trade is not the root cause of yen weakness, it reinforces the broader trend created by monetary policy and global capital flows.

Why Intervention Has Limits

Against this backdrop, foreign exchange intervention is better viewed as a tool for smoothing market volatility than changing the market's long-term direction.

When Japanese authorities intervene, tthey use part of their foreign exchange reserves, held largely in US dollar assets including US Treasuries, to purchase yen. The additional demand for the currency can produce a sharp appreciation over hours or days, particularly when markets are heavily positioned against the yen. Recent intervention episodes suggest authorities are most willing to act when moves become unusually rapid or disorderly. Japanese officials consistently emphasise that they are responding to excessive and disorderly currency movements rather than defending a particular exchange-rate level, even if markets often speculate about informal thresholds.

The problem is that intervention does little to change the underlying incentives facing investors.

That was evident in 2022, when Japan intervened repeatedly after the yen fell to multi-decade lows. The currency strengthened immediately after each operation, but the gains proved temporary because US interest rates continued to rise while Japanese monetary policy remained highly accommodative. The economic forces driving capital towards the dollar simply overwhelmed the intervention.

A similar story unfolded in 2024. Japanese authorities again spent tens of billions of dollars supporting the yen after USDJPY climbed above 160. The intervention triggered an impressive short-term rally in the currency, but the more durable recovery came as expectations shifted towards easier US monetary policy and Treasury yields moved lower. As the outlook for US monetary policy shifted, the dollar weakened more broadly, giving the yen much firmer support. The episode highlighted the important lesson that intervention works best when it reinforces a change already taking place in market fundamentals, rather than attempting to fight against them.

What Would Turn the Tide?

For now, the backdrop still favours the dollar. US economic activity has remained relatively resilient, Treasury yields are elevated, and investors continue to view the Federal Reserve as considerably more hawkish than the Bank of Japan. Although Japanese policymakers have begun raising interest rates, borrowing costs remain low by international standards, limiting the support they can offer the currency.

A sustained recovery in the yen would therefore require more than another round of intervention. US interest rates would likely need to fall meaningfully, reducing the return advantage of dollar assets. The yield gap between US Treasuries and Japanese government bonds would need to narrow, making Japanese investments relatively more attractive. The Bank of Japan would also need to continue normalising monetary policy convincingly enough for investors to believe the era of ultra-low Japanese interest rates is genuinely ending. At the same time, large carry-trade positions would probably need to unwind, creating renewed demand for the yen as investors repay their yen borrowings.

None of those developments can be created by intervention alone. They depend on broader changes in monetary policy, economic conditions and the direction of global capital flows.

Japan can still slow the pace of the yen's decline. Intervention can buy policymakers time, discourage speculative excesses and calm disorderly markets. But unless the underlying interest-rate gap begins to close, those effects are unlikely to prove lasting. The yen's weakness is ultimately a reflection of diverging monetary policies, and until those fundamentals change, Japan may be able to slow the currency's fall, but probably cannot stop it.

References

• reuters.com
• reuters.com
• mof.go.jp