The Japanese yen has weakened dramatically against the dollar and the euro over the past four years, falling from roughly 110 to the dollar in early 2021 to above 155 by late 2025. For Japanese investors, this has been painful. For American and European investors, it may be something quite different: an entry point.

Currency movements are notoriously difficult to predict, and anyone who claims certainty about where the yen is headed should be treated with scepticism. But the structural forces that drove the yen to multi-decade lows are beginning to shift, and investors who understand those forces can make a more informed judgement about whether yen-denominated assets belong in their portfolio.

How the yen got here

The yen’s weakness has a straightforward explanation. From 2022 onward, the Federal Reserve raised interest rates aggressively to combat inflation, eventually pushing the federal funds rate above 5%. Meanwhile, the Bank of Japan maintained its ultra-loose monetary policy, keeping rates at or near zero. The resulting interest rate differential made the yen carry trade enormously profitable: borrow in yen at near-zero rates, invest in dollar assets yielding 5%, and pocket the spread.

This carry trade was not a hedge fund curiosity. It became one of the largest and most crowded trades in global finance. As capital flowed out of yen and into dollars, the yen weakened further, which made the trade even more profitable, which attracted more capital, which weakened the yen further. The result was a self-reinforcing cycle that pushed the currency to levels not seen since the mid-1990s. The flip side of this dynamic is that Japanese financial institutions, which hold enormous portfolios of both domestic and foreign bonds, are among the most direct beneficiaries when rates normalise and the carry trade unwinds.

Why the cycle may be turning

The forces that drove the yen down are now moving in the opposite direction.

The Federal Reserve is expected to cut rates in 2026, with market consensus pointing to at least two reductions. Under incoming Fed Chair Kevin Warsh, the administration’s preference for lower rates and a weaker dollar may accelerate this timeline. Treasury Secretary Bessent has been explicit about wanting to bring down long-term yields.

Meanwhile, the Bank of Japan has moved decisively in the other direction. After raising rates to 0.75% in December 2025, the BOJ has signalled that further hikes are coming. Board members have discussed a terminal rate in the range of 1.0% to 1.5%, and some market participants expect it could go higher. The interest rate differential that powered the carry trade is narrowing.

When carry trades unwind, the effects can be sudden. A preview occurred in August 2024, when a modest BOJ rate adjustment triggered a sharp yen rally and cascading liquidations in global equity and cryptocurrency markets. The January 2026 JGB sell-off provided another reminder of how quickly Japanese capital flows can shift.

What this means for foreign investors in Japanese equities

For a dollar-based or euro-based investor, the currency component of a Japanese equity investment is not just a risk to be hedged. It can be a significant source of return.

Consider a simple example. You buy a Japanese stock that returns 10% in yen terms over the next two years. If the yen also appreciates 10% against the dollar over that period, your return in dollar terms is roughly 21%. The equity return and the currency return compound. This double tailwind is something that domestic US equity investments cannot provide.

The reverse is also true. If the yen weakens further, it detracts from your return. This is why the direction of the currency matters for your allocation decision.

The structural case for yen appreciation rests on the narrowing interest rate differential, which is driven by policy decisions that have already been signalled by both central banks. This does not guarantee the outcome, but it does suggest that the balance of probabilities has shifted from where it was two years ago, when the differential was widening.

Purchasing power parity suggests undervaluation

There are several ways to assess whether a currency is overvalued or undervalued. None of them are reliable timing tools, but they provide context.

On a purchasing power parity basis, the yen appears significantly undervalued against the dollar. The Economist’s Big Mac Index, a rough but widely followed measure, has consistently shown the yen as one of the most undervalued major currencies. More sophisticated models from the IMF and academic researchers reach similar conclusions.

Undervaluation does not mean immediate appreciation. Currencies can remain cheap for extended periods. But it does suggest that the risks are asymmetric. A currency that is already near multi-decade lows and fundamentally undervalued has more room to appreciate than to depreciate further.

The hedging question

US and European investors in Japanese equities face a choice: hedge the currency exposure or leave it unhedged.

Hedging eliminates the currency risk but also eliminates the currency opportunity. It has a cost, which varies with the interest rate differential. When the differential is wide, as it has been recently, hedging is expensive. And if you believe the yen is likely to appreciate, hedging is not just expensive but counterproductive, because you are paying to remove what could be a positive contributor to your return.

Currency-hedged Japan ETFs like DXJ have their place, particularly for investors who want pure equity exposure without currency noise. But for investors who view yen appreciation as part of the thesis, unhedged exposure through vehicles like EWJ or BBJP, or through direct purchases of Japanese stocks via an international broker, preserves the full return potential.

A considered view

The yen at current levels represents either fair value in a world where Japanese rates stay low and American rates stay high, or a significant opportunity in a world where those conditions are changing. The evidence suggests the conditions are changing.

This is not a call to make a leveraged bet on the yen. It is an observation that for investors who are already considering Japanese equities on their merits, the currency dimension adds another layer of potential return that is worth understanding and factoring into the decision.

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