The interest rate differential between Japan and the United States supports the dollar exchange rate—factors that are becoming the focus of the market

The interest rate gap between Japan and the United States continues to have a significant influence on the foreign exchange market. In early February, financial analysis institutions pointed out that the U.S. borrowing costs far exceed those of Japan, serving as a supporting factor for the dollar exchange rate. This structural difference in interest rates is a key element influencing market participants’ investment behavior.

Expanding Interest Rate Differential – Divergence in U.S. and Japanese Policies

The Federal Reserve currently maintains interest rates at 3.50% to 3.75%. Meanwhile, the Bank of Japan recently decided to shift away from its zero interest rate policy and raised rates to 0.75%. This level of 0.75% remains low in the global interest rate environment, resulting in an almost 3% interest rate differential between Japan and the U.S.

This substantial interest rate gap is not just a number but functions as a direct factor affecting market participants’ investment decisions. The strategy of borrowing low-yielding yen and investing in relatively higher-yielding U.S. assets continues to appear attractive.

Carry Trade Supporting the Market – Continued Arbitrage Opportunities

In an environment with a large interest rate differential, carry trade strategies become more active. Specifically, this involves borrowing yen, which has low interest rates, and investing in high-yield currencies or assets. As long as the interest rate gap exists, investors seeking profit from the spread will continue to be attracted.

The current size of the interest rate differential between Japan and the U.S. sustains these arbitrage transactions, maintaining strong demand for the dollar. Many market participants expect this dynamic to continue for the time being, supporting the dollar exchange rate.

Increasing Market Volatility – Attention to Fluctuation Risks

However, this market environment carries inherent risks. Carry trades are highly sensitive to market fluctuations, and unexpected price movements can quickly unwind positions. If the interest rate gap narrows or sudden market swings occur, traders who have been aiming for profits may rapidly reverse their positions, potentially causing significant market movements.

Another concern is the risk of intervention by the Japanese government and the Bank of Japan to buy yen. If the yen’s exchange rate falls beyond a certain level, authorities might intervene in the market. Such intervention could accelerate the unwinding of carry trade positions.

Future Focus – Policy Trends in Japan and the U.S.

The future trajectory of interest rate policies in Japan and the U.S. will be a major focus for the foreign exchange market. If the U.S. proceeds with additional rate cuts, the interest rate differential will narrow. Similarly, if Japan continues to raise rates, the gap will also decrease. In either scenario, the current carry trade environment may be forced to change, and market participants need to remain highly alert to potential policy shifts.