How do differing interest rates between the US and Japan affect the yen?

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Differing Interest Rates Between the US and Japan Drive Yen Weakness Through Carry Trade

The significant disparity between interest rates in Japan and those in the United States and other major economies is a primary factor contributing to the yen's depreciation. This interest rate differential incentivises investors to engage in a practice known as the "carry trade," where they borrow funds in low-interest-rate currencies like the yen and invest them in assets denominated in higher-yielding currencies elsewhere. Such capital outflows exert downward pressure on the yen's value.
The Carry Trade Mechanism

The core of the yen's weakness lies in the lucrative opportunities presented by the "carry trade." Investors can borrow at very low rates in Japan, where interest rates have remained historically low, and then convert these yen into currencies like the US dollar to invest in assets offering substantially higher returns. This strategy is profitable as long as the exchange rate does not move significantly against the investor, and the interest rate differential remains wide.
Capital Outflows and Yen Depreciation

The execution of the carry trade directly leads to capital outflows from Japan. As investors sell yen to purchase foreign currencies for their investments, the demand for the yen decreases, while the supply in the foreign exchange market increases. This imbalance naturally pushes the value of the yen lower relative to other major currencies, such as the US dollar. The yen recently slid to its weakest level since 1986 against the dollar, reaching 163.24, a move exacerbated by these outflows.
Impact of Monetary Policy Divergence

The divergence in monetary policy between Japan and the US, particularly the Federal Reserve's stance on interest rates, is a critical element. While the US has pursued a path of higher interest rates to combat inflation, the Bank of Japan has maintained its ultra-loose monetary policy. This difference is expected to persist, with markets anticipating potential further rate hikes by the US Federal Reserve, which would only widen the interest rate gap and potentially intensify the carry trade activity, further pressuring the yen.

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How do differing interest rates between the US and Japan affect the yen?

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