USD/JPY slipped after two sessions of gains, trading near 160.10 in Asian hours on Tuesday, as the Japanese Yen held firm after the Bank of Japan’s latest policy decision. The BoJ lifted its short-term interest rate by 25 bps to 1% at the end of its two-day review, matching market expectations and keeping the pair on the back foot.
Falls in the pair may be limited, however, with the US Dollar supported by caution ahead of further news on US-Iran peace talks. Neither Washington nor Tehran has published an official agreement text, and major shipping lines are delaying vessel rerouting through the Strait of Hormuz until greater transparency emerges. While US President Donald Trump said an MoU had been signed to end the conflict and reopen the waterway, Iran’s semi-official Mehr news agency reported the draft envisages reopening within 30 days under Iranian arrangements. Separately, the Federal Reserve is widely expected to leave rates unchanged at 3.50% to 3.75% on Wednesday.
Carry Trade Dynamics And Policy Outlook
We are seeing the USD/JPY pair pull back after a strong run, but we view any significant dip as a buying opportunity. The Bank of Japan (BoJ) is providing some support for the Yen, but its policy normalization is proving to be extremely gradual. This underlying dynamic suggests the path of least resistance for the pair remains upwards.
The BoJ recently ended its negative interest rate policy, bringing its key rate to a range of 0% to 0.1%, but it has signaled extreme caution about further hikes. With Japanese inflation hovering just above 2.5%, the central bank is also only slowly reducing its massive bond-buying program. We expect that even by this time in 2026, the BoJ’s policy rate will likely not exceed 0.50%, maintaining a vast policy gap with the US.
In contrast, while the Federal Reserve has likely completed its cutting cycle from the highs of 2023, its policy rate remains firm around a 3.00% to 3.25% range. This interest rate differential of over 2.5 percentage points creates a powerful incentive for carry trades, which involves borrowing Yen to invest in higher-yielding US dollars. This fundamental driver will continue to put a floor under the USD/JPY exchange rate.
Geopolitical Tensions, Dollar Demand, And Strategic Positioning
Geopolitical risks are also providing support for the US Dollar, which acts as a safe-haven currency. Ongoing tensions in the Middle East regarding shipping lanes have kept energy prices volatile, with Brent crude futures consistently trading above $80 a barrel. This uncertainty encourages capital flows into dollar-denominated assets, limiting the downside for the currency.
Furthermore, we are approaching a period of uncertainty at the Federal Reserve itself, as Chairman Jerome Powell’s term is set to expire. The market will be sensitive to any news regarding his potential reappointment or replacement, which introduces volatility that traders can use. This leadership question adds another layer of caution that tends to benefit the dollar.
Given this backdrop, we are advising traders to use options to express a bullish view on USD/JPY while managing risk. Selling out-of-the-money JPY call/USD put options allows for collecting premium, capitalizing on the view that the pair will not fall sharply. This strategy takes advantage of the volatility created by geopolitical news and Fed uncertainty.
We saw a similar setup in 2022-2023 when the rate gap widened significantly, driving the pair from 115 to over 150. Historical precedent suggests that as long as the wide interest rate differential persists, the fundamental pressure on the Yen remains. This makes sharp, sustained JPY appreciation unlikely in the coming weeks.
