Will the yen depreciate despite interest rate hikes? The market is betting on a $500 billion "psychological game."

The phenomenon is quite surreal: When the central bank raises interest rates, the currency still depreciates

Last Friday, the Bank of Japan announced a rate hike to 0.75%, hitting a 30-year high. Investors initially thought the yen would rise accordingly. But what happened? USD/JPY instead broke through 157.4, and the yen continued to fall. Wall Street’s message is clear: We don’t believe you’ll actually raise rates aggressively.

According to estimates from Morgan Stanley, there are still about 500 billion USD in open yen arbitrage positions worldwide. These funds borrow cheap yen in Japan and then invest in US Tech Stocks, Indian equities, and cryptocurrencies. The logic is simple: even if Japan raises interest rates to 0.75%, the US interest rate differential of over 4.5% remains too attractive. The market is betting that the next rate hike by the central bank won’t happen until June 2026, so the yen won’t appreciate rapidly in the short term, and arbitrage trading will continue.

Cryptocurrencies become the “liquidity canary”

The most sensitive reaction appeared in the crypto market. As soon as the rate hike news was announced, Bitcoin plummeted from above $91,000 to struggle around $88,500, a nearly 3% drop in one day. According to CryptoQuant data, after the last three Bank of Japan rate hikes, Bitcoin experienced corrections of 20% to 30%. If history repeats, and yen arbitrage positions are liquidated in the coming weeks, $70,000 could become the next critical support level. Notably, real-time data shows Bitcoin has fallen to $87.41K, down 0.54%.

The US bond market hints at bigger trouble

More concerning than exchange rate fluctuations is the surge in US Treasury yields. After the rate hike, Japanese institutional investors (one of the largest holders of US Treasuries globally) began considering “capital repatriation.” The US 10-year Treasury yield jumped to 4.14% last week. This “bear steepening” phenomenon indicates that the long end of the yield curve is rising not because of overheating economy, but because the largest buyers are starting to withdraw. The direct consequence? US corporate financing costs rise, putting invisible pressure on the valuation of US stocks in 2026.

The ripple effect of Japan’s 10-year Treasury yield movements is also driving global asset re-pricing. When the Bank of Japan’s rate hike decision begins to transmit to the global bond markets, the entire arbitrage economic model becomes increasingly fragile.

2026: A race of interest rates is about to unfold

Next year, the market’s winner depends on who can run faster—The Federal Reserve’s rate cuts vs. the Bank of Japan’s rate hikes.

Scenario 1 (current market pricing): The Fed slowly cuts to 3.5%, the Bank of Japan remains on hold, the interest differential remains attractive, US and Japanese stocks both benefit, and USD/JPY stays above 150.

Scenario 2 (high risk warning): US inflation rebounds, Japanese inflation spirals out of control, and the central banks are forced to hike rates rapidly. The interest differential narrows instantly, the $500 billion arbitrage positions panic and flee, USD/JPY surges to 130, and global risk assets crash.

Goldman Sachs warns that if USD/JPY breaks below the psychological level of 160, the Japanese government may intervene, which could trigger artificial volatility and spark a deleveraging wave.

Three major risk indicators to watch closely

160 level support: If USD/JPY hits 160, intervention risk is extremely high. This is not the time to go long on the yen.

$85,000 support: Cryptocurrencies have become the leading indicator of global liquidity. If Bitcoin drops below $85,000, it indicates institutional investors are withdrawing liquidity from the highest-risk assets—often a precursor to a risk-averse cycle.

Changes in real US bond yields: As financing costs rise, capital will rotate out of high-valuation, low-cash-flow tech stocks and into defensive sectors like industrials, consumer staples, and healthcare. The speed of this rotation directly reflects market confidence in the Fed’s policies.

The current situation is clear: the market is selectively deaf, collectively betting that the Bank of Japan won’t dare to raise rates further. But when reality hits back, how fast will the $5 trillion in arbitrage capital flee? No one can say for sure.