“Fiscal Anxiety and Prospect of a Wider US-Japan Rate Gap”: Yen Falls to Lowest Level in Nearly 40 Years as Tax Cuts Emerge as a New Risk

Yen pressured by the Honebuto policy framework and expectations of persistently high US interest rates
Markets positioned for further depreciation as the impact of official intervention proves temporary
Takaichi government’s tax-cut agenda risks generating additional foreign-exchange instability

The Japanese yen has plunged to its weakest level in decades. Market anxiety has intensified as the government of Prime Minister Sanae Takaichi signals greater fiscal expenditure and the possibility of influencing Bank of Japan policy, while the prolonged conflict in the Middle East has added further pressure through higher energy prices and expectations of rising US interest rates.

Against this backdrop, market participants are warning that the government’s planned tax reductions, which have yet to be accompanied by a clear financing strategy, could impose additional downward pressure on the yen and deepen instability across Japan’s bond and foreign-exchange markets.

Yen Depreciation Accelerates

According to the Nihon Keizai Shimbun on July 21, the yen weakened sharply in the New York foreign-exchange market, with the dollar briefly rising above ¥163. The level exceeded the previous monthly high of ¥162.84 and marked the weakest yen exchange rate since December 1986. Several factors contributed to the extreme movement. One was the Takaichi government’s recently prepared Basic Policy on Economic and Fiscal Management and Reform, commonly known as the Honebuto policy. The document emphasized the administration’s intention to expand public investment and promised close communication with the Bank of Japan, creating the impression that the government could seek to influence the central bank’s interest-rate decisions. The language triggered selling in the government bond market, and the yield on Japan’s 10-year government bond climbed to 2.9% in early July, its highest level in approximately 30 years. The government attempted to contain the damage by adding a note to the final policy document stating that specific monetary-policy instruments would remain the responsibility of the Bank of Japan, but the clarification had little practical effect on market sentiment.

The renewed military confrontation involving the United States, Israel, and Iran has also contributed to the yen’s decline. The longer the conflict continues, the more rapidly US defense expenditure is likely to increase, raising the probability that Washington will issue additional Treasury securities to finance the burden. A sharp increase in bond supply generally leads investors to demand higher yields as compensation for absorbing the additional volume and accepting greater fiscal risk. US policy rates are also likely to remain elevated for an extended period. If disruptions to Middle Eastern oil supplies push energy prices higher, US consumer inflation and inflation expectations may rise together, making it more difficult for the Federal Reserve to cut rates.

Persistently high US interest rates directly weaken the yen. When yields on dollar-denominated assets such as US Treasury securities remain substantially higher than those available in Japan, global investors have a stronger incentive to expand yen carry trades, borrowing at relatively low Japanese interest rates and investing the proceeds in higher-yielding US bonds and financial products. The resulting increase in yen selling and dollar buying pushes the exchange rate higher and reduces the value of the Japanese currency. Rising oil prices create an additional vulnerability because Japan is a major energy importer. A larger requirement for dollars to pay for imported fuel, combined with a deterioration in the trade balance, could place further pressure on the yen.

Speculative Pressure Persists Despite Government Intervention

Financial markets had already committed substantial capital to bets on further yen depreciation before the latest escalation in the Middle East. Data on yen futures positions collected by the US Commodity Futures Trading Commission show that hedge funds and other speculative investors shifted from a net-long yen position at the end of 2025 to a net-short position in February 2026 and subsequently increased their bearish wagers rapidly. Speculative net-short positions exceeded 110,000 contracts at the end of May and reached 145,800 contracts in the second week of June, the highest level recorded in several years.

As speculative demand intensified and instability became increasingly visible, the Japanese government intervened in the foreign-exchange market. According to the Ministry of Finance, the authorities spent a total of ¥11.7349 trillion, or approximately $72 billion, between April 28 and May 27 purchasing yen and selling dollars. After speculation spread on April 30 that the government had entered the market, the exchange rate fell within several hours from above ¥160 per dollar to approximately ¥155, while the yen experienced additional intermittent gains through early May. The movement was widely interpreted as evidence that the authorities had conducted several rounds of dollar selling during the period. The precise intervention dates and the amount sold on each day are expected to be confirmed in quarterly data scheduled for release in August.

The defensive effect did not last long. By the end of May, the exchange rate had returned to approximately ¥159 per dollar, close to the level recorded immediately before the intervention, and it remained around ¥160 throughout June. Once the impact of the purchases faded, traders began testing the government’s willingness to defend the currency, attempting to determine the exchange-rate level at which the authorities might intervene again. Verbal warnings alone were no longer considered sufficient to reverse capital flows. In response, the Japanese government reportedly shifted away from its previous practice of issuing repeated warnings before entering the market and adopted a more unpredictable intervention strategy intended to conceal the timing of its actions. If the government’s threshold becomes too obvious, speculative investors can exploit it by selling the yen and closing their positions immediately before the authorities begin purchasing the currency.

Limits of a Tax-Centered Inflation Strategy

Some market participants warn that foreign-exchange instability could intensify further because Japan’s policies for addressing inflation may themselves weaken the yen. The Takaichi government is currently seeking to reduce the consumption tax rate on food from 8% to 1% for a temporary period of two years, fulfilling a pledge made by the prime minister during the House of Representatives election in February. Takaichi had originally promised a temporary complete exemption from the tax, but technical limitations in the point-of-sale systems used by supermarkets and other retailers obstructed the plan. The Yomiuri Shimbun reported in June that industry representatives had informed the government that modifying systems to support a zero rate could take as long as one year, whereas the introduction of a 1% rate could be completed in approximately six months. The administration therefore chose to implement a smaller but more rapid reduction even though it would not fully satisfy the original campaign promise.

The central question is how the government will replace the revenue lost after the tax reduction. The Daiwa Institute of Research estimates that lowering the food consumption tax from 8% to 1% would reduce annual government revenue by approximately ¥4.4 trillion, or about $27 billion, while increasing gross domestic product by only around ¥300 billion, or approximately $1.8 billion. The expected economic stimulus would therefore be far too limited to compensate for the decline in tax receipts. Takaichi has stated that the government will not rely on additional deficit-financing bonds, but the administration has yet to identify a specific alternative source of funding.

If Japan, which already carries one of the world’s largest public-debt burdens, proceeds with major tax reductions without a credible financing plan, investors are likely to demand higher yields in exchange for holding long-term government bonds. An increase in rates caused by concerns over fiscal deterioration rather than expectations of monetary-policy normalization would raise the government’s interest burden and could undermine confidence in Japanese assets more broadly. Under such a scenario, investors could sell both Japanese government bonds and the yen, accelerating the simultaneous rise in bond yields and decline in the currency. The Bank of Japan could also face growing political pressure to prioritize bond purchases and market stabilization over further interest-rate increases. The resulting conflict between monetary tightening intended to contain inflation and intervention intended to limit the government’s financing costs could deepen doubts over the central bank’s ability to respond effectively to a foreign-exchange crisis.