How does the interest rate differential between Japan and the US affect the yen?

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The Interest Rate Differential Drives Yen Weakness Through Carry Trades

The significant gap between interest rates in Japan and those in the United States and other major economies has been a primary factor in the yen's depreciation. This disparity encourages investors to engage in "carry trades," where they borrow funds in low-interest yen to invest in higher-yielding assets abroad. Such activities lead to capital outflows from Japan, thereby exerting downward pressure on the yen's value.
Carry Trade Mechanism

The practice of carry trade involves exploiting interest rate differentials. Investors borrow at a low rate in a currency like the yen, where interest rates have remained exceptionally low for an extended period. They then convert these borrowed yen into other currencies, such as the US dollar, to invest in assets that offer a higher return. This strategy is profitable as long as the gains from the higher yield outweigh any potential losses from currency fluctuations.
Capital Outflows and Yen Depreciation

When a substantial number of investors participate in carry trades, it results in a significant outflow of capital from Japan. As yen are sold to purchase other currencies for investment, the demand for the yen decreases, and its supply in the foreign exchange market increases. This imbalance directly contributes to a weakening of the yen against other major currencies. The yen's slide to its weakest level in decades, including reaching 163.24 per dollar, is indicative of these persistent capital outflows.
Impact of US Interest Rate Policy

The widening interest rate gap is exacerbated by the monetary policy decisions of central banks like the US Federal Reserve. As the Federal Reserve has raised interest rates to combat inflation, the yield differential between US dollar-denominated assets and yen-denominated assets has become more pronounced. This increasing divergence further incentivises carry trades and amplifies the downward pressure on the yen, as markets anticipate potential further rate hikes by the Fed.

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How does the interest rate differential between Japan and the US affect the yen?

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