Since 2012, the narrative surrounding the yen has been simple and can be summed up in one word: bearish. Over the past 14 years, JPY has fallen by nearly 50% versus USD (Figure 2). Although JPY did get a small post-election bounce, over the past year it has been the weakest among the major currencies (Figure 3).

Fiscal expansion can be a double-edged sword for a currency. On the one hand, currency traders usually favor currencies with shrinking budget deficits over currencies with expanding budget deficits. This could argue for further yen weakening. On the other hand, currency investors also tend to favor currencies with an accelerating rate of economic growth relative to those with slowing growth. If Japan’s fiscal stimulus results in a faster pace of economic growth, this could counteract any nervousness that investors have with respect to the potential growth in Japan’s budget deficits. 

Fiscal expansion could also impact monetary policy creating potential feedback loops. Japanese government bond (JGB) yields have been soaring as the Bank of Japan (BoJ) has begun raising rates (Figure 4).

Higher bond yields will, by definition, raise Japan’s cost of financing its debt. In the U.S., for example, as bond yields began rising in 2021 and the Federal Reserve (Fed) began tightening in 2022, the cost of financing the U.S. debt rose from 1.25% to 3.2% of GDP. A similar process will almost inevitably occur in Japan where the average residual maturity of Japan’s debt is around 9 years. In other words, approximately one-ninth of Japan’s debt matures each year and will have to be refunded at higher yields. For the fiscal year ending March 31, 2026, Japan’s Ministry of Finance estimates that ¥135.8 trillion of JGBs will need to be issued to finance maturing debt. This amounts to 20.4% of GDP worth of debt – in a single year. For every 1% rise in the average interest rates, this automatically adds 0.2% of GDP to Japan’s cost of funding and budget deficit. 

Meanwhile, if the fiscal stimulus raises growth and inflation, it could lead to higher bond yields and further BoJ rate rises. Already, the BoJ has been raising rates in recent years, even as most of its peers have been cutting, because Japan’s inflation rate remains stubbornly above target (Figures 5 and 6).

Despite the BoJ’s rate hikes, Japan’s level of real interest rates is still very low compared to its peers. The BoJ’s policy rate is currently around 2.5% below the level of core inflation. Most other nations with similar standards of living have their real policy rates between -1% and +1% (Figure 7).

There are three key possibilities with fiscal expansion:

1. Larger budget deficits, by definition, mean greater debt issuance, which could push yields further upwards. 
2. Greater fiscal stimulus could boost real growth, which also typically correlates to higher bond yields. 
3. Fiscal stimulus in an economy with a tight labor market and above-target core inflation could further boost inflation as new spending competes with scarce resources elsewhere in the economy. 

The unanswered question is to what extent are these concerns already reflected in bond yields? Is there further room for bond yields to rise? Already the yield gap between JGBs and U.S. Treasuries has been narrowing. In the past, such yield gaps have often correlated with movements in USDJPY but that hasn’t been the case in the past couple of years. Moreover, the narrowing yield gaps suggests that it’s possible that JPY could have significant upside versus USD, particularly if Japanese yields continue to trend higher versus Treasury yields (Figures 8 and 9).

So, what’s holding the yen back from rallying? Part of it might be concern over the size of Japan’s public debt. Japan’s public debt amounts to 209.3% of GDP as of June 30, 2025, according to the Bank of International Settlements. By way of comparison, the public debt in the U.S. is “only” one half of that amount at 105.9% of GDP. The combination of larger budget deficits stemming from both additional fiscal stimulus and rising debt service costs might be weighing on JPY to such an extent that not even higher Japanese interest rates can counteract those concerns. 

As such, there are two broad possibilities for the yen’s future:

1. Faster growth and higher yields boost the yen to a major recovery versus USD.
2. Larger budget deficits and increasing funding costs pull the yen lower. 

Which of these two narratives wins out could also impact Japanese equities from both JPY and USD perspectives. Japanese stocks have, for the moment, reacted favorably to the potential of additional fiscal stimulus and the rally has been especially powerful when viewed from a yen perspective (Figure 10).

This is likely because when viewed from a yen perspective, Japanese stocks tend to benefit from a weaker JPY. By contrast, when viewed from a dollar perspective, a strong JPY usually correlates to higher stock prices (Figure 11).

A steeper yield curve is also a double-edged sword for Japanese stocks. On the one hand, steeper yield curves usually mean greater profitability for banks which borrow from depositors short term and lend long term. The steeper the curve, the greater the potential profitability of lending. Often, steep yield curves presage credit expansion and faster economic growth. At the same time, rising bond yields might eventually siphon investor capital away from equity markets. The risk of this happening might be especially acute now that the valuation ratios of Japanese equities are no longer as cheap as they were relative to U.S. stocks.