In this insight we analyse Japan’s policy normalisation and its implications for USD/JPY and the Japanese yen carry trade into 2026. It explains why a Q3 growth setback, a steeper JGB curve, rising fiscal sensitivity, and more reactive Bank of Japan signalling are increasing carry risk and tightening global funding conditions. It also explores why institutional positioning is pivoting towards the Swiss franc as a cleaner funding leg. Aimed at macro investors, FX traders, and risk managers.
How weakening growth, policy risk, and a shifting safe-haven hierarchy are reshaping the Japanese Yen carry trade in 2026
We return to Japan looking at the policy normalisation and the Japanese yen carry trade. We delve further by explaining why it is becoming a more demanding proposition as Japan absorbs a Q3 growth setback and markets reassess how quickly the Bank of Japan can normalise policy without unsettling domestic demand, the JGB curve, or global funding conditions.
Then further examine how a steeper curve, rising fiscal sensitivity, and a more reactive BoJ are reshaping USD/JPY dynamics and the risk profile of the Japanese yen carry trade. We also assess why institutional positioning is quietly pivoting towards the Swiss franc over the Japanese yen as a cleaner funding leg into 2026.
The Regime Shift: From Mechanical to Live
What has changed in late 2025 is not Japan’s policy destination, but the market’s pulse. Market sentiment has shifted from a slow, stable mechanical narrative into a regime where policy probabilities reprice quickly and the yen responds immediately. Through October and early November, the dominant frame was an orderly exit: gradual hikes, a managed reduction in bond purchases, and a controlled narrowing of the US-Japan gap. That comfort is somewhat eroded.
USD/JPY pushed through ¥155 after Japan’s GDP revision, revealing just how fragile the recovery remains. Q3 output contracted -2.3% annualised, down -0.6% q-o-q, the first decline in six quarters. Markets had been leaning towards a December hike, with expectations clustered around a move from 0.50% to 0.75%. The GDP downgrade has not removed that outcome, but it has sharpened the trade-off the BoJ must now defend.
The Japanese yen’s behaviour confirms the shift. When a 7.5 magnitude earthquake struck Japan’s northeast, the currency held somewhat steady, briefly pulling markets into a risk-off posture before tsunami warnings were downgraded. USD/JPY floated around ¥155-¥157, a reminder that the yen is no longer governed by its long held safe-haven status alone. In this current cycle, Japan is not merely the crucial funding base. It is a live macro transition, and transitions change how FX markets are priced.
With wage momentum still firm and inflation persistence increasingly tied to domestic pay dynamics rather than one-off shocks, the market is now trading Japan through a risk management lens. The yen firms when investors believe the BoJ can lean into credibility, and weakens when growth fragility forces hesitation.
In this regime, the yen is less a passive funding leg and more a live macro instrument, reacting to each data print and each nuance of central bank language. The baseline remains known. The distribution around it has widened, and that widening is what the yen is pricing day to day.
The Policy Tightrope: Weighing Up the Options
This is the balancing act Governor Ueda faces after missing the window for an autumn hike. What’s at stake? Tighten too slowly and yen weakness feeds into higher import prices and household costs, threatening to stall the inflation progress the BoJ has spent years trying to engineer. Tighten too quickly and domestic demand risks deteriorating further, already on thin ice. There is no straightforward policy path here. Only trade-offs, and the discipline of choosing which discomfort is more tolerable.
Japan’s Normalisation: Gradual by Design, Until Now
The BoJ has begun withdrawing accommodation, though the pace remains cautious. The policy rate is still low by global standards, and the normalisation path remains measured. That gradualism is not indecision. It is an operating principle after two decades of ultra-loose policy. When a system has been entrenched in near-zero rates for a generation, timing becomes a source of instability.
Our combined monetary policy sentiment index captures Japan’s transition from a prolonged ultra-easy regime to an increasingly credible normalisation path. Sentiment is sharply negative in 2016, stabilises around neutral through 2017–2021, and becomes more volatile from 2022 as markets begin to price the conditions for policy change. The upswing into 2024-2025 marks a clear inflection, with sentiment rising as the BoJ moves rates off the long-standing floor and the debate shifts from “if” to “how far” normalisation can go.
What has shifted is not the direction of travel, but the narrative regime surrounding it. Market sentiment has moved ahead of action. Rates stayed static for long stretches, but sentiment shows drifts, firms, and then builds well before the BoJ delivers a step change. Once normalisation begins, the signal becomes higher beta, with larger swings as pressure builds around each nuance of BoJ action or inaction. In short, the market pulse determines the path first, and reprices faster once the perception is under way.
Market Pricing: The Conviction Has Firmed
Market expectation is still leaning strongly toward a BoJ hike in December. Overnight index swaps now imply roughly a 80%-90% chance of a 25 bp increase at the meeting, a conviction that has strengthened since Governor Ueda’s more hawkish signalling and the firmer wage backdrop.
The bigger message, though, sits beyond the next decision. Five-year JPY OIS has repriced to around 1.38%, almost double where it started the year, while one-month JPY OIS two years forward has jumped to roughly 1.47% from 1.14%. What has become more apparent is that markets are no longer pricing Japan as an ultra-loose forever regime. They are quietly lifting the expected floor for Japanese rates and assigning more weight to a normalisation path that extends well past a single hike.
Placed into the bigger picture, investors are positioned for Fed easing alongside BoJ tightening, which should narrow the US-Japan rate gap and, all else equal, support the yen. The constraint is communication. The BoJ’s emphasis on a gradual, data-dependent exit limits how far markets can extrapolate the hiking cycle. So the signal the market is seeing is a narrowing rate gap being yen-supportive, but slow normalisation can keep USD/JPY from breaking lower in a clean move.
The Wage Paradox: Progress That Complicates
If GDP is the argument for caution, wages pull towards normalisation. October pay data showed nominal wages rising 2.6% y-o-y, the fastest pace in three months, supported by base pay, overtime, and bonuses. Overtime increased 1.5% y-o-y, a useful signal that labour demand is not simply holding up on paper. More important still is the forward signal. Unions are pressing for wage hikes of 5% in next spring’s negotiations, echoing the gains of the past two years. That matters because Japan’s inflation story hinges on whether wage-setting becomes baked into the norm.
The underlying issue is that households feel squeezed. In real terms, wages fell -0.7% y-o-y in October 2025, the tenth consecutive monthly decline, as consumer prices continue to outpace earnings growth, with headline CPI at 3.0% y-o-y and food inflation at 6.4% y-o-y in the latest data. Nominal wage momentum supports the case for persistent inflation and further normalisation. Real wage weakness caps how quickly tightening can proceed before it collides with household sentiment and consumption. The wage channel is doing the heavy lifting, being the bridge between inflation credibility and domestic resilience, and increasingly depends on which the BoJ’s sequencing turns.
The Fiscal Wildcard: Sanaenomics and Sustainability in Question
Newly sworn-in Prime Minister Sanae Takaichi begins her tenure under a cloud of political uncertainty and fragile market confidence. Fiscal policy is now at the forefront of the yen’s risk premium. The government’s stimulus package has been framed at roughly ¥21.3tr, with planned fresh spending around ¥17.7tr. It is designed to ease household inflation via subsidies and relief, support wages and smaller firms, and reinforce longer-term strategic priorities. It is set to prop up growth, and a stronger growth profile can feed through into core inflation and justify a steadier hiking path.
The harder, more complex set of issues arises from fiscal sustainability and spillovers. With public debt already above 200% of GDP, markets are reactive to any mere hint that fiscal expansion could become structurally entrenched, particularly when the BoJ is also tapering. This is how fiscal sentiment becomes FX-relevant: not by changing growth forecasts overnight, but by shifting the perceived boundary between fiscal ambition and monetary constraint.
Furthermore, the geopolitical dynamics compounds the current risk premium. The recent tensions with China matter because Japan is exposed through tourism, trade, and corporate confidence. If visitor flows from mainland China and Hong Kong were to stall materially, the drag on growth could be meaningful at the margin. In a period where the BoJ is trying to normalise without breaking demand, marginal growth drags can have outsized FX consequences.
The JGB Curve: Supply Pressure Meets Policy Transition
The bond market is not waiting politely. The curve has steepened as attention shifts from policy certainty to supply, term premia, and perceived stress. The 10-year JGB yield sits near 1.97%, the 30-year around 3.386%. Part of this reflects policy expectations, but a growing share reflects Japan’s balance sheet: money supply dynamics, the BoJ’s reduced marginal presence, and a heavier issuance backdrop.
The issuance profile implies meaningful additional bond supply. The result: heavier supply at the long end, a central bank slowly reducing its footprint, and a market that demands a higher term premium. Monetary conditions remain accommodative even as long yields rise, which is precisely what makes the trade-off so awkward.
The BoJ is walking a policy tightrope. It does not want to work against fiscal policy, but it also cannot ignore what heavier issuance is doing to the curve. If policy stays too loose as supply rises, the risk is higher term premia and renewed inflation pressure. Markets are already pricing policy rates drifting towards 1.00%-1.50% over time, even without explicit guidance. The key issue is whether the BoJ is implicitly allowing the neutral rate to be marked higher as wage and inflation persistence improve.
That repricing is also interacting with fiscal supply. Higher issuance to fund the stimulus package, combined with a central bank trying to normalise, pushes yields higher across the curve. For the yen, the effect is not linear. Rising yields can support the currency via narrower differentials, but if the yield rise is interpreted as supply pressure and fiscal anxiety, it can coincide with yen weakness. The market’s interpretation matters as much as the move itself.
The United States: Easing Cycle Underway – But How Far?
Japan’s dilemma only amplifies when measured against the Fed’s position.
The United States sits in a different place. The Federal Reserve has begun easing from a peak of 5.25%, with Decembers expected cut imminent, policy is expected to settle in the low 3% range by late 2026. That is a meaningful shift, but it is easing from altitude, not capitulation.
Growth is cooling but remains firmer than in most advanced economies. Investment linked to artificial intelligence continues to support capital spending, while labour income has remained resilient. Tariffs introduced through 2025 have raised import prices and complicated the disinflation process. The Fed can ease, but it cannot appear complacent.
The result is that the interest rate gap between Japan and the United States narrows through 2026, but it does not close. Even under a dovish Fed scenario, the US is still expected to maintain roughly a 150 to 200 bp advantage over Japan. The cushion is thinner, but it remains supportive for positive USD/JPY carry.
The FX Translation: How the Japanese Yen Responds
The shaded bars decompose daily monetary policy sentiment across rates, QE and other policy themes, set against USD/JPY (black line) on the right axis. As Monetary policy sentiment turns bearish into late November and early December, USD/JPY retreats from its highs, consistent with a firmer yen backdrop as Fed easing collides with Japan’s gradual normalisation.
With the USD/JPY trading in the mid-¥150s. The GDP release pushed the pair above ¥155 and reminded markets how sensitive the currency is to Tokyo’s data flow. Forecasts for late-2026 cluster around ¥144 to ¥148 as the rate differential compresses and Japan’s normalisation path becomes more credible. A ¥145 end-2026 level remains a reasonable central case if Japan delivers gradual hikes and US policy eases without a reacceleration in inflation.
Intervention remains an ongoing constraint. The ¥157 to ¥160 range has historically triggered official discomfort, particularly when currency weakness overlaps with fiscal expansion and rising household costs. The political tolerance for depreciation has its limit in a cost-of-living environment.
The Japanese yen remains undervalued in many fair-value frameworks. But valuation is not the driving spot. Policy differentials and policy credibility are. The tension is visible, the yen needs higher domestic rates to stabilise, yet higher rates are harder to justify when growth is waning and households are still losing real purchasing power. If the BoJ delays tightening, the yen stays weak and import costs rise. Inflation pressure eventually forces action anyway. The adjustment is delayed, not avoided.
For most of the recent years, USD/JPY has tracked the US-Japan 10-year yield spread closely. The relationship still holds, but the short-term driver has changed. Japanese macro news now moves the pair more quickly than it did under the old regime. Data surprises matter again, and that is the defining shift.
A ¥153 to ¥155 year-end range is plausible if the BoJ delivers in December and the Fed easing cycle remains measured. Above that, the market will watch whether the move is driven by US strength or Japanese hesitation, because the political response differs.
The Japanese Yen Carry Trade Crossroad
Yen funding has been the backbone of cross-border carry for two decades. Borrow cheap, buy higher yield, roll. That trade is still viable, but the cushion is thinner. As the US-Japan gap compresses through 2026, the Japanese yen carry trade returns fall. At the same time, the risks rise: intervention risk, more FX sensitivity to BoJ language, and a steeper JGB curve that changes hedging economics.
The structural detail matters. A large share of global yen funding flows through FX swaps rather than straightforward cash borrowing. Synthetic funding is efficient in calm markets, but it is more sensitive to volatility and risk limits. When the yen strengthens sharply, unwinds can become reflexive. In a thinner carry world, path risk dominates. The challenge is no longer finding spread. It is surviving the move that forces the unwind
Enter the Swiss Franc
When the primary funding currency becomes the trading risk itself, alternatives gain appeal.
As Japan’s policy landscape becomes more unpredictable and complex, some investors are rotating part of their funding and hedging structure towards the Swiss franc. The appeal is not higher carry. It is a cleaner, more risk free profile.
Switzerland’s policy rate has been held around 0%, inflation has been subdued, and the SNB has historically leaned against excessive franc strength. That means the policy risk, when it appears, tends to cap CHF strength rather than defend against weakness. CHF is not risk-free. It can strengthen sharply in risk-off episodes. But those risks usually originate in global market episodes, not domestic policy sequencing. Japan’s risk is both global and domestic because the market is repricing a regime change. That is why CHF-funded carry can gain share at the margin even if the headline yield gap is smaller.
Market Sentiment’s Role in Strategy: Trading the Corridor
Japan’s exit from ultra-easy policy was always going to be gradual. What is striking now is how narrow the corridor has become. A weaker growth print, firmer wage persistence, heavier fiscal issuance, and a currency that transmits living costs all pull policy in different directions. The BoJ is spinning multiple plates. Even exogenous shocks can weigh on sentiment without delivering a clean safe-haven rally, because the market is repricing Japan’s regime rather than simply responding to risk.
For FX traders and asset managers, the spread remains, yet the cushion is wearing thin. The edge in 2026 will come from reading market sentiment shifts and inflection points in policy, growth fragility or inflation credibility, and positioning before shifts are priced into broader market moves.
If you want to trade this regime with more discipline, the advantage comes from seeing market sentiment shifts early and measuring them consistently. Our Regional Macro Indices and FX market sentiment signals track the policy, fiscal, inflation, and geopolitical narratives that drive repricing in real time, turning headlines into structured, tradeable intelligence.
To access our full regional macro indices coverage and real time sentiment feeds to help your risk strategy, reach out to enquiries@permutable.ai