Will the Euro/Japanese Yen still rise? Interest rate differential trading and central bank policies are the key.

Recently, many investors have been asking: how much longer can the EUR/JPY cross still rise? Actually, this is a good question because it involves one of the most interesting trading logic in the forex market—interest rate differential trading.

Why does EUR/JPY have more potential than the spot pair?

In the forex market, besides direct USD exchange, there are cross currency trades between other currencies. EUR/JPY is one of the highest-volume yen cross pairs, and its volatility is often more intense than that of EUR/USD spot pairs.

For example, in March 2023, when the European Central Bank announced a 0.5% rate hike, the market was surprised by this hawkish stance. The euro immediately strengthened, but EUR/USD’s gains were modest—because the dollar’s interest rates were higher. But then something interesting happened: since Japan was still at zero interest rates, interest rate differential traders flooded in, resulting in EUR/JPY rising 1.1% within four hours, which was 8.5 times the increase of EUR/USD during the same period.

The logic of interest rate differential trading is simple: borrow low-interest currency (JPY), invest in high-interest currency (EUR), and profit from the interest rate spread. This strategy works very well in optimistic economic conditions, but once market risk appetite declines or policy shifts, a wave of closing positions can be very fierce.

What does the history of EUR/JPY tell us?

Since the euro started circulating in 2002, this currency pair has experienced several turning points:

2002-2007 was the golden era for the euro, with Europe’s economy strong and Japan’s growth weak, pushing EUR/JPY close to 170.

The 2008 financial crisis shattered this. Market risk appetite plummeted, funds flocked to safe-haven yen, and EUR/JPY plunged to around 112.

The 2010 euro debt crisis again dampened the euro, causing this cross to fall to 94 at one point.

But from 2012 onward, the situation reversed. Europe’s economy gradually stabilized, and Japan launched “Abenomics” with large-scale easing policies to stimulate growth, leading to yen depreciation and EUR/JPY rising again, nearing 149.

After the COVID-19 pandemic in 2020, global central banks relaxed policies, and interest rate differential trading demand surged. As inflation rose in 2021, the European Central Bank began raising rates, while the Bank of Japan remained dovish, further pushing EUR/JPY higher.

The key question: Will the Bank of Japan change?

The current focus is not on Europe but on Japan.

The European Central Bank has clearly entered a rate hike cycle, with even the ECB President appearing more hawkish than the Federal Reserve. Citibank’s analysis also suggests that the ECB’s tightening pace may be faster than the US. In the short term, the probability of EUR/JPY continuing to strengthen is high.

But what about Japan? The new Bank of Japan Governor Ueda Kazuo, under high inflation pressures, is likely to be forced to reassess its long-standing ultra-loose policies. Rising oil prices and ongoing disruptions in global supply chains are also pushing up Japanese prices.

Once the Bank of Japan truly changes its policy stance, interest rate differential trading will reverse. Large-scale yen borrowing investors will be forced to close positions, leading to a rare yen appreciation wave, and EUR/JPY will enter a long-term downtrend.

How to seize this opportunity?

If you want to trade EUR/JPY, you should watch for these signals:

Short-term trading: Follow technical indicators, such as RSI crossing above 70 into overbought territory and then falling back below 70—that’s a good sell signal. The golden and death crosses of MACD can also help you determine entry and exit points. Combining trend lines and support/resistance levels can significantly improve your win rate.

Medium-term logic: Keep a close eye on economic data from Japan and Europe—CPI, GDP, unemployment rate. When Eurozone data is strong and Japan’s economy stagnates, consider buying EUR/JPY; when Japanese inflation data continues to rise, watch for BOJ statements, as a policy shift could be imminent.

Long-term risk: Don’t forget the possibility of a policy change by the Bank of Japan. Once confirmed, the yen’s strengthening could last for a decade, making shorting EUR/JPY the biggest opportunity.

In essence, the future of EUR/JPY depends on a simple question: when will the Bank of Japan give in to inflation pressures? Whoever spots this turning point first will gain an advantage in the market.