A weak yen spells trouble for Japan—at home and abroad
Amid reports of Japan’s current account surplus hitting record highs and international investors losing confidence in the US dollar, the story would seem straightforward: as the dollar falters, the yen should be soaring. But that’s not what’s happening.
Instead, defying conventional expectations, the yen continued to weaken in late June, touching a four-decade low of ¥162.8 per US dollar as the greenback climbed to a thirteen-month high. Over the past year, the US currency has gained 4.5 percent.
So what’s going on? As I have argued before, the answer lies beyond the headlines and requires separating short-term fluctuations from long-term structural shifts in economic behavior.
Why the yen has shrugged off record surpluses and rate hikes
Despite Japan becoming an economic powerhouse and integrating more deeply into the global economy, the yen has been on a long-term weakening trend since the 1990s. This trend is largely driven by structural forces. These include persistent interest rate differentials between Japan and other major economies, substantial outward investment by Japanese corporations and financial institutions, the country’s aging and shrinking population which has suppressed growth and inflation, and a shift from large trade surpluses to more balanced trade positions, or even deficits, as higher energy and raw material imports pushed up costs.
Occasionally, cyclical corrections have strengthened the yen, but they have never been enough to reverse the broader downward trend. And recently, the yen has remained under pressure despite developments that would traditionally have supported its exchange value.
In FY 2025, ending in March 2026, Japan posted a record current account surplus of ¥34.4 trillion, roughly $219 billion, up 15 percent from the previous year. This trend has continued into FY 2026. In addition, the Bank of Japan (BOJ) has repeatedly raised its policy rate, which now stands at 1 percent, and signaled readiness to tighten further in response to rising energy prices. The BOJ has also intervened in FX markets to the tune of $73 billion in recent months. Based on past experience, these measures should have strengthened the yen.
This time, however, things have played out differently for several reasons. Importantly, the country’s current account surplus has been driven almost entirely by primary income, which rose to roughly ¥42.3 trillion, around $263 billion, in FY 2025. At the end of last year, Japan’s net international investment position reached a record high of more than ¥561 trillion, around $3.5 trillion. However, Japanese corporations and institutional investors have largely kept those earnings overseas instead of converting them into yen, which could have supported the currency.
Meanwhile, Japan’s structural capital outflow has been reinforced by the recently revamped Nippon Individual Savings Account, first launched in 2014. The reforms expanded tax-exempt investment allowances for foreign securities, encouraging Japanese households to shift more savings from bank deposits into equities, including overseas markets.
These two forces—persistent capital outflows and foreign earnings remaining overseas—continue to weigh on the yen. The only meaningful interruptions have come when capital outflows temporarily slow. The most important example has been the unwinding of yen-based carry trades, driven by determined BOJ tightening rather than foreign-exchange interventions alone. Notably, US Treasury Secretary Scott Bessent has ruled out joint intervention—which would likely be more effective—while stressing instead the need for the BOJ to tighten further to underpin the yen.
Carry trades and dollar cycles are shaping exchange rates
Basically, Japan’s persistently low interest rates relative to those abroad, especially in the US, have encouraged international investors to borrow—or short—the yen and invest the proceeds in higher-yielding currencies. This so-called yen-based carry trade has grown significantly. The Bank for International Settlements (BIS) estimates its size at anywhere from $261 billion in direct cross-border bank borrowing to around $1 trillion when off-balance-sheet derivatives and forward markets are included, and as much as $11.3 trillion when broader speculative short positions are taken into account.
In normal times, yen-based carry trades exert downward pressure on the yen. Occasionally, however, BOJ tightening can narrow the interest-rate gap more than markets expect, triggering an unwinding of these positions through the repayment of yen-denominated borrowing and the covering of short positions. That, in turn, pushes the yen higher. One example of this occurred in August 2024, when the unwinding of yen-based carry trades caused the yen to appreciate by more than 12 percent within three weeks. For that reason, investors should pay as much attention to signs of carry-trade unwinding as to BOJ interventions.
By contrast, the dollar’s current strength remains primarily cyclical, supported by the Federal Reserve’s hawkish response to rising inflation following the Iran war, as well as stronger USgrowth and equity-market performance driven by the AI investment boom.
However, many market participants expect the dollar to soften later this year if the conflict in the Middle East subsides, energy prices ease, and investment in AI loses momentum, reducing upward pressure on inflation and interest rates. That process may already have begun following last week’s release of weaker-than-expected employment data for May.
If that cyclical support fades, longer-term vulnerabilities are likely to become more visible. These include persistently large budget deficits, which are currently around $2 trillion per year (5.8 percent of GDP) and expected to rise to $3.1 trillion by 2036; unilateral and unpredictable trade policy decisions under the Trump administration; and efforts by many countries to reduce dependence on the US, including through de-dollarization. If left unchecked, these trends could harden into structural forces weighing on the dollar.
A new flash point in US-Japan relations?
Looking ahead, the combination of structural yen weakness and cyclical US dollar strength could become a new source of friction between Washington and Tokyo. Seeking to reduce the US trade deficit, the Trump administration has repeatedly challenged trade practices that it perceives as unfair, including its partners’ alleged attempts to maintain undervalued currencies. And given the persistent yen weakness, Washington has kept Japan on the Treasury’s 2026 monitoring list.
At the same time, BOJ efforts to intervene in FX markets to support the yen—for instance, by selling US Treasury securities to raise dollars for intervention—could reinforce the net liquidation of US Treasuries by foreign official institutions, a trend that has continued for the past four years and has reduced their share of outstanding holdings to a thirty-year low of 13 percent. That could place additional upward pressure on Treasury yields—or at least increase volatility—as ownership shifts toward more price-sensitive private investors. From Washington’s perspective, neither outcome would be desirable. Consequently, yen weakness combined with US dollar strength is likely to remain a persistent irritant in US-Japan economic relations—and one that will not be easy to resolve in the foreseeable future given its structural roots.
Hung Tran is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center, a senior fellow at the Policy Center for the New South, a former executive managing director at the Institute of International Finance, and a former deputy director at the International Monetary Fund.
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Image: A macro close-up of US dollar and yen banknotes. Source: iStock.