The yen's safe-haven aura rapidly fading

Ask AI · How will Japan’s central bank policy dilemma affect the FX outlook?

Amid a surge in global risk-off sentiment since U.S. and Israeli military strikes against Iran over the past little more than a month, the foreign-exchange market has displayed a completely different picture from past experience: the Japanese yen, which has traditionally served as a safe-haven currency, has not strengthened as in previous crises. Its USD exchange rate has been sliding steadily, even breaking through the key psychological level of 160 yen per 1 U.S. dollar, hitting a new two-year low. The yen, once viewed as a “safe haven” for capital, has been rapidly losing its luster under the combined pressure of both an international geopolitical crisis and Japan’s domestic economic structural contradictions.

This shift is first driven by the huge uncertainty created by Japan’s over-ambitious domestic macro policy. The fiscal expansion measures introduced by the Takaichi Sanae administration in late 2025 will raise the budget size for fiscal year 2026 to a high of 122.3 trillion yen, with nearly one quarter of it relying on newly issued government bonds. Japan’s total government debt-to-GDP ratio has already exceeded 260%. This kind of fiscal model lacking clear sources of funding—essentially “borrowing to pay for more borrowing”—has severely shaken international market confidence in Japan’s fiscal sustainability and the stability of the yen’s value, becoming the largest crack in the foundation of yen credit.

The deeper shock comes from Japan’s energy weak spot. As a resource-poor island nation, Japan depends on imports for more than 90% of its crude oil, with the overwhelming majority transported through the Middle East. If passage through the Strait of Hormuz is disrupted, international oil prices will jump, which is effectively like an “imported inflation storm” for Japan. Rising oil prices worsen Japan’s terms of trade, meaning Japan has to pay more yen to purchase energy in order to buy it with dollars, thereby exacerbating the trade deficit and creating sustained downward pressure on the yen exchange rate. According to related research from the Nomura Research Institute, this crisis could lower Japan’s real GDP by 0.65% while pushing up prices by 1.14%. When a local geopolitical conflict directly damages Japan’s economic fundamentals, capital will not flock to the yen for safety; instead, it may accelerate its flight due to Japan’s economic vulnerability.

Market preferences that support yen strength are changing. In the past, when global risk increased, Japan’s large overseas companies and investors would bring profits and assets back to the domestic market on a massive scale, generating strong demand for the yen. Analysts note that after the pandemic, Japanese companies were more inclined to keep funds overseas to reinvest or reallocate them, rather than to repatriate them during crises. This change has caused the yen to lose a substantial portion of its intrinsic support. When external shocks arrive, without the hedge of domestic capital repatriation, the yen is more easily affected by one-way selling pressure.

The large interest-rate spread between the U.S. and Japan has created sustained downward pressure on the yen. Over the past few years, U.S. interest rates staying at high levels led to sizable carry trades: investors borrowed low-cost yen, exchanged them into dollars or other high-yield currency assets, and earned the interest differential. After the Bank of Japan raised rates in late 2025, its policy rate was only 0.75%, leaving an interest-rate spread of up to around 3% between it and the U.S. federal funds rate. When global conditions are turbulent, closing out these trades may temporarily support the yen, but in most cases, the mere existence of the spread acts like a magnet, continuously attracting capital outflow from Japan and exerting a long-term, fundamental drag on the yen.

Under a complicated situation, the Bank of Japan’s monetary policy has fallen into a dilemma that weakens its ability to support the exchange rate. On one hand, to curb imported inflation and support the yen, the Bank of Japan needs to tighten monetary policy and accelerate its rate-hike pace. The minutes of the Bank of Japan’s March meeting show that some members have already warned that high oil prices could lead to a stagflation-like situation where economic stagnation and price increases coexist, and they discussed the possibility of further rate hikes. On the other hand, rate hikes could choke off Japan’s fragile economic recovery, worsen the burden of interest payments on the government’s huge debt, and even trigger volatility in the government bond market. The trade-off between supporting growth, fighting inflation, and stabilizing the exchange rate leaves the Bank of Japan’s policy signals ambiguous, preventing it from providing clear and strong support to the yen—and instead exacerbating the market’s wait-and-see attitude and doubts.

The rapid fading of the yen’s safe-haven attribute is the result of multiple conflicts breaking out at once, including Japan’s domestic fiscal risks, excessive energy dependence, changes in market behavior, a large external interest-rate spread, and the central bank’s policy dilemma. Against the backdrop of a profound evolution in the global economic landscape and Japan’s own structural problems becoming increasingly prominent, global investors need to reassess the yen’s asset characteristics and recognize that the risk landscape behind it is becoming more and more complex. (Source of this article: The Economic Daily, author: Lian Jun)