Quora Answer: Is There a Correlation between a Weak Yen & High Interest Rates in Japan?

The following is my answer to a Quora question: “Is there a correlation between a weak yen and high interest rates in Japan?”

Japan is the world’s fourth-largest economy.  It is also Exhibit A in what happens when a government spends three decades trying to outsmart a problem it created.  The weak yen is not a mystery.  It is the consequence of decisions made in the 1990s, compounded by decisions made in the 2000s, compounded again by decisions made in the 2010s, and now coming due at a time when the rest of the world has moved on, and Japan has not.  The correlation between a weak yen and high interest rates is real.

The Bubble and the Hangover

Japan’s asset bubble burst in 1990.  At its peak, the land beneath the Imperial Palace in Tokyo was said to be worth more than the entire state of California.  The Nikkei 225 hit 38,957 on 29^th December 1989.  It would not revisit that level for thirty-four years.  What followed was not a recession.  It was a generation-long stagnation.  Japan’s nominal GDP in 2023 was nearly identical to what it was in 1995.  An entire economy flatlined for three decades.  By 2024, Japan’s GDP per capita had fallen to 24^th among 38 OECD members — its lowest ranking since comparable data began — at US$33,785.  For context, South Korea and several Eastern European nations now have higher per capita incomes on a purchasing power parity basis.

The cause was not laziness.  Japan has some of the most industrious people on earth.  The cause was deflation.  When prices fall consistently, consumers postpone spending.  When consumers postpone spending, revenues fall.  When revenues fall, companies cut wages and investment.  This causes prices to fall further.  The loop is self-reinforcing and brutally hard to break.  Japan spent thirty years trying to break it.  Its primary tool was interest rates.  But monetary policy cannot fix a structural problem.  Japan had several.

Where Japan Went Wrong

The thirty-year stagnation was not inevitable.  It was a choice — made in boardrooms, in ministries, and in a political culture that treated the avoidance of short-term pain as a governing philosophy.  The first failure was the banks.  When the bubble burst, Japanese banks were sitting on catastrophic loan losses.  The correct response was to recognise those losses, write down the bad debt, let insolvent borrowers fail, and recapitalise the survivors.  Every economy that has recovered from a credit crisis — South Korea after 1997, the United States after 2008 — did some version of this.  Japan did not.

Instead, Japanese banks engaged in what economists call “zombie lending.”  They kept rolling over loans to insolvent borrowers — companies that could not service their debt at any commercially viable rate — rather than recognising the losses on their books.  By the mid-1990s, more than 25 per cent of publicly traded firms in the affected sectors qualified as zombies, kept alive by subsidised credit.  By the early 2000s, that figure was closer to 30 per cent.  The banks met minimum capital requirements only because regulators declined to look too closely.

The cost was not just the bad loans themselves.  Zombie firms, sustained by cheap credit, kept prices artificially low, held onto workers they did not need, and crowded out the investment and hiring that healthy firms would have done.  New businesses could not enter markets where the walking dead were competing on subsidised terms.  Productivity stagnated across entire industries.  Economists at Chicago Booth estimated taxpayer losses from the crisis at a minimum of 20 per cent of GDP.  Japanese banks reported no net operating profit for more than a decade.

The second failure was structural reform.  Japan’s economy in the 1990s needed deregulation, labour market flexibility, and a dismantling of the keiretsu cross-shareholding structures that bound banks and corporations together in webs of mutual obligation.  None of this happened at the scale required.  The political cost was too high.  Corporate Japan and the Liberal Democratic Party had coexisted for decades on the basis that established firms and their workforces would not be sacrificed for efficiency.  That arrangement did not survive a bubble, but it did survive its aftermath — which is why the problem persisted.

Former Prime Minister Shinzo Abe’s “Abenomics,” launched in 2012, was the most serious attempt at structural reform in a generation.  The first arrow — monetary stimulus — was delivered with force.  The second — fiscal stimulus — was partially deployed, then undermined by a 2014 consumption tax hike that throttled demand.  The third arrow — structural reform — failed to leave the quiver.  Seven years in, inflation was  0.5 per cent against a 2 per cent target.  A January 2014 Kyodo poll found that 73 per cent of Japanese respondents had not noticed any effect from Abenomics, and only 28 per cent expected a pay rise.  Japan’s 32 companies in the world’s top 50 by market capitalisation in 1989 had fallen to one by 2018.

The third failure is demographic, and it is irreversible.  Japan’s total fertility rate hit a record low of 1.15 in 2024 — the lowest in modern Japanese history.  Births fell below 700,000 for the first time, to 686,061.  The projected fall to 680,000 by 2039 arrived fifteen years early.  Japan’s population shrank by 919,000 in 2024 alone — its eighteenth consecutive year of net decline.  The number of people paying into the social security system has fallen by 3 million, while beneficiaries have risen 40 per cent.

A shrinking workforce cannot generate the consumption growth that breaks a deflationary spiral.  An ageing population saves more and spends less, compounding the demand problem.  Immigration, the only short-term fix, ran against a cultural resistance so entrenched that Japan’s immigration figures remained negligible for decades while the working-age population contracted.

These three failures — zombie banking, failed structural reform, and demographic collapse — are why interest rates had to stay at or below zero for the better part of three decades.  The Bank of Japan was not being eccentric.  It was compensating, with monetary policy, for failures that monetary policy cannot fix.  The problem with compensating for structural failure with cheap money is that cheap money eventually finds its own use.  In Japan’s case, it funded the largest currency carry trade in history.

The Interest Rate Experiment

The Bank of Japan began cutting rates in the early 1990s.  By 1999, the overnight rate was effectively zero.  Zero was not enough.  Deflation persisted.  So, in January 2016, the Bank of Japan did something that would have seemed deranged to any previous generation of central bankers: it went negative.  It charged commercial banks 0.1 per cent to park excess reserves.  The logic was that if holding cash cost money, banks would lend it.  Businesses would borrow.  Investment would rise.  Demand would recover.  Prices would inflate.  The thirty-year deflation death spiral would finally end.  It did not work.  Not in the way intended.

What negative rates did do was create an extraordinary yield gap between Japan and the rest of the world.  By the time the US Federal Reserve had raised its funds rate to 5.25 to 5.50 per cent in 2023 and 2024, the spread between Japanese and American short-term rates was more than five percentage points.  Five percentage points on a leveraged position is not a yield gap.  It is a licence to print money, and the market treated it as one.

Yield Curve Control: The Policy That Ate Itself

In September 2016, then-Governor of the Bank of Japan Haruhiko Kuroda introduced yield curve control.  The Bank would not just set short-term rates.  It would pin the yield on ten-year Japanese government bonds at around zero per cent, buying whatever quantity of bonds was necessary to hold that line.  This was intervention at a scale the bond market had never seen.  By 2023, the Bank of Japan owned more than half of all outstanding Japanese government bonds.  It was buying bonds to suppress yields on debt it had, in large measure, helped the government issue.  The circularity was breathtaking.

The stated purpose was to keep borrowing costs low, stimulate investment, and generate inflation.  What it did was cap the return available on Japanese assets, making Japan one of the least attractive destinations for yield-seeking capital on earth.  Every global investor who wanted a return had to look elsewhere.  They did.  The yen weakened.  Capital left.  The Bank of Japan printed more yen to buy more bonds.  This weakened the yen further.  This made imports more expensive.  This generated cost-push inflation — the wrong kind, driven by higher import prices rather than stronger domestic demand — while real wages fell for two consecutive years.

By July 2023, the Bank raised the yield cap to 1 per cent.  By October 2023, it redefined the cap as a “loose reference,” which is a polite way of saying it had abandoned the policy without admitting it.  In March 2024, under new Governor Kazuo Ueda, yield curve control was formally dismantled and the negative rate policy ended after eight years.  The yen was trading at 157 to the dollar.  It was at its weakest level in thirty-four years.

The Carry Trade: Japan as the World’s Cash Machine

The interest rate differential between Japan and the rest of the world created one of the largest carry trades in modern financial history.  The mechanics are four steps.  Borrow yen at near-zero cost.  Convert to US dollars.  Invest in US Treasuries at 5 per cent, or in US equities for even higher returns.  Pocket the difference.  Repeat.  By early 2024, BIS data showed yen-denominated claims on non-banks outside Japan had reached US$880 billion.  Yen loans to non-banks outside Japan stood at US$271 billion.  Hedge fund yen forward positions added another US$160 billion.  The total implied yen supply flowing into the carry trade — by BIS methodology — had risen by the equivalent of US$435 billion between end-2021 and early 2024.  These are the figures that can be measured.  The positions that cannot be measured are almost certainly larger.

The carry trade is not risk-free.  It has one fatal vulnerability: if the yen strengthens, or if Japanese rates rise, the trade reverses.  Borrowed yen become more expensive to repay.  Leveraged positions face margin calls.  The entire structure — built on the assumption that Japan would remain the world’s low-rate anomaly indefinitely — goes into reverse at once.  That is what happened in August 2024.

The Unwind

On 31^st July 2024, the Bank of Japan raised its policy rate to 0.25 per cent and signalled further tightening.  Simultaneously, soft US labour market data raised expectations of Federal Reserve rate cuts, narrowing the yield differential from both ends.  The yen had been trading at around ¥162 to the dollar in early summer.  Within weeks, it rallied to ¥142.  A 12 per cent move in a currency that the entire global carry trade had bet against, compressed into days.  The Nikkei 225 fell over 10 per cent in a single session on 5^th August 2024 — one of its worst days since the 1987 crash.  The three-day decline was the worst for Japanese equities in data going back to 1973.  The Nasdaq entered correction territory.  The S&P 500 and the Dow fell 7 per cent from their highs.  The US 10-year Treasury yield dropped from 5.02 per cent to 3.71 per cent as capital fled risk assets.

This was not a Japan crisis.  Japan’s underlying businesses had not changed.  What unwound was a leveraged financial position of extraordinary size that had been built on the assumption that the Bank of Japan would never move.  When it moved — by a quarter of a percentage point, the most timid of hikes — the system shook.  That is the correlation.  High interest rates elsewhere, against near-zero rates in Japan, created the differential that funded the carry trade.  When Japanese rates rose even modestly, the differential narrowed.  The carry trade unwound.  The yen strengthened.  Global markets convulsed.

The Current Position

In January 2025, the Bank of Japan raised rates again to 0.5 per cent — the highest level since 2008, and an 8-1 vote in favour.  The yen responded with a 0.5 per cent appreciation to ¥155.32 against the dollar.  Half a per cent, on the news of the highest rate in seventeen years.  The market’s indifference tells you everything.  The interest rate differential between Japan at 0.5 per cent and the United States at 4.25 to 4.50 per cent is still more than four percentage points.  Japan is still the cheapest source of borrowed money in the developed world.  The carry trade is not over.  It is merely more expensive than it was.

The Bank of Japan aims to push rates toward 1 per cent.  The Bank of Japan is still far away from neutral.  To reach a true neutral rate — one that neither stimulates nor restricts — Japan would need rates somewhere around 2 to 3 per cent.  At the current pace of quarter-point increments, that is years away.  During those years, the yen will remain structurally weak relative to currencies of countries where rates are higher.

The weak yen is not a policy choice.  It is the residue of a thirty-year battle with deflation, fought with increasingly desperate tools, that produced a financial architecture the world learned to exploit.  Japan printed money to buy bonds to suppress yields to stimulate growth.  The growth did not come — not in the quantity needed.  What came instead was the largest single-currency carry trade in history, a currency priced for permanent stagnation, and an economy whose nominal size in 2023 was barely larger than it was in 1995.  Japan kept rates at zero or below while the world raised them.  The differential created a one-way bet.  Every hike the Bank of Japan makes reduces that differential slightly.  It does not eliminate it.  Japan is normalising, cautiously.  The yen will recover, in time.  The carry trade will continue unwinding, in stages.  The next time it does, global markets will shake again.  The only question is how much of the trade is left to unwind.  Nobody knows.  When a financial structure of this size operates in the shadows of international banking statistics, the answer is a market event.  Japan’s thirty-year experiment in monetary extremism has not ended.  It has entered its denouement.

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Terence Nunis | Executive Chairman, Equinox Zenith | Author, The 1% Playbook: The Billionaire Cheat Code