USD/JPY has recently diverged from its usual link with US–Japan yield spreads. Instead, it has started to show a negative correlation, largely due to specific risks in Japan. The new government’s potential fiscal problems could keep the yen weak, even if interest rate differences narrow. Historically, USD/JPY closely tracked the differences in short-term US-Japan rates, particularly the 2-year spread. This had been a key part of its fair value model, which also considered implied volatility, risk reversals, and other economic factors.

Discrepancy in Spot Rate and Fair Value

Since October, there has been a noticeable gap between the spot rate and fair value. Regression models reveal this, as the correlation between USD/JPY returns and US-Japan yield spreads has sharply declined. Before October 2025, the 12-week average correlation was +0.43, reaching a high of +0.91 in February. After October 2025, however, it fell to -0.07, with eight straight weeks of negative correlation. This indicates that USD/JPY is now more influenced by Japan-specific risks rather than US rate changes. Fiscal uncertainty stemming from Prime Minister Sanae Takaichi’s administration and a larger budget is likely to keep the yen weak, even as yield spreads narrow. The connection between USD/JPY and US-Japan interest rate differences has weakened. Now, risks unique to Japan have a greater impact than US monetary policies. Our past models based on yield spreads no longer apply effectively in this environment. The data confirms this change, showing that the correlation between USD/JPY and the 10-year yield spread has been negative for the past eight weeks. This marks a clear shift from earlier in the year when the correlation was positive, peaking at +0.91 in February. Such a divergence indicates a fundamental change in market behavior.

Fiscal Uncertainty Under New Administration

This separation seems to be driven by fiscal uncertainties under Prime Minister Sanae Takaichi. The recent approval of a ¥29.1 trillion supplementary budget has raised concerns about Japan’s fiscal health, pushing the 10-year JGB yield to 1.15%. This domestic pressure is keeping the yen weak, even as the US Federal Reserve hinted at a possible pause in its November meeting. Things were different in 2022 and 2023; then, the widening interest rate gap drove USD/JPY to multi-decade highs. The straightforward relationship, where higher US yields led to a stronger dollar against the yen, no longer applies. The old strategy of just monitoring central banks is outdated. For derivative traders, this change means that strategies solely focused on Federal Reserve or Bank of Japan interest rate decisions may struggle. We should expect that policy announcements will have much less impact on the currency’s direction than before. The new focus should be on assessing Japan’s domestic political and fiscal risks. Given this shift, using options to navigate the increased uncertainty could be a smart approach. Buying USD/JPY call options may be a good strategy for those anticipating a weak yen due to its internal challenges, regardless of narrowing yield spreads. With 1-month implied volatility now around 10%, up from 7.2% in the third quarter, strategies like long straddles might also be suitable ahead of important fiscal announcements from Tokyo. Create your live VT Markets account and start trading now.

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