The USD/JPY exchange rate continued its ascent during Monday's Asian trading session, rising approximately 0.3% to 161.76 at the time of writing. Despite Japanese Finance Minister Shunichi Suzuki reiterating that authorities "will take appropriate action in the foreign exchange market as needed," the market's reaction to official verbal intervention remained muted.
In the face of the yen's persistent weakness, Citigroup has released a significant report providing an in-depth analysis of the logic behind the yen's decline. The bank constructed two valuation frameworks to estimate the fair value of USD/JPY. The first model, using market data from 2017 to 2025, estimates the fair value at around 161 yen per US dollar. The second model, using a shorter timeframe from 2023 to 2025, yields a slightly lower valuation of approximately 159 yen per dollar. Results from both models point to the current exchange rate level—indicating that, from Citigroup's perspective, the USD/JPY rate is currently neither significantly overvalued nor undervalued.
The bank noted that the supportive effect of narrowing interest rate differentials for the yen has been offset by weakness stemming from the strong performance of Japanese equities, bringing the exchange rate close to equilibrium. Citigroup sets the long-term upper limit for USD/JPY around 160 and anticipates a correction in the exchange rate during the second half of this year, forecasting it to fall below 155 yen per dollar by year-end.
Whether Citigroup's 155 target is achievable will depend on whether the Bank of Japan can resolve the policy contradiction of concurrently raising interest rates and purchasing bonds in the latter half of the year, and whether there will be a marginal softening in the Federal Reserve's hawkish expectations. Before these factors materialize, the record low of 161.95 set in 1986 may serve as the market's most realistic short-term benchmark.
Market Forces in Broad Balance, Yet Yen Faces Multiple Pressures
Citigroup believes the current USD/JPY exchange rate is neither significantly overvalued nor undervalued. The bank points out that the supportive effect of narrowing interest rate differentials has been counteracted by yen weakness driven by the historic strength of Japanese stock markets. The strong performance of Japanese equities might encourage foreign investors to increase currency hedging for their Japanese stock holdings, thereby exerting additional selling pressure on the yen.
A prior research report from Bank of America corroborates this view. The report suggests that part of the recent yen weakness may be due to foreign investors hedging their exposure to Japanese stocks, rather than a deterioration in Japan's economic fundamentals. It estimates that foreign investors hold approximately $2.2 trillion in Japanese stocks as of March 2025, roughly equivalent to the value of overseas stocks held by Japanese investors. These hedging-related capital flows could amount to trillions of yen, helping to explain the discrepancy between the yen's performance and balance of payments data.
Bank of America notes that Japan's loan-to-deposit gap has narrowed since 2024, while, in dollar terms, Japanese domestic bank stocks have outperformed their US peers. Analysts state these developments indicate improving financial conditions. The report points out that if Japanese equities continue to outperform global markets, the yen may remain under pressure. Over the past year, Japanese stocks have significantly outperformed global markets, with the Nikkei 225 Index surpassing 72,000 points. This outperformance could prompt foreign investors to increase currency hedging for their Japanese equity positions, adding further selling pressure on the yen.
The report further indicates that if Japanese stock market outperformance persists, the yen may stay under pressure; conversely, if the equity outperformance fades, hedging-related selling pressure could ease.
The Interest Rate Gap: Rate Hikes Struggle to Halt Yen Depreciation
Although the Bank of Japan, in its June 16 monetary policy meeting, decided by a 7-1 vote to raise the policy rate from 0.75% to 1.0%, marking the highest level in 31 years, the rate hike provided very limited support for the yen. The fundamental reason is that the interest rate gap between the US and Japan remains wide and deep. After the BOJ raised the short-term rate to 1%, the US federal funds target range remains at 3.50% to 3.75%, resulting in a nominal policy rate differential of 2.50 to 2.75 percentage points. Some analysis notes that even after the hike to 1%, the nominal US-Japan rate differential remains as high as approximately 345 basis points. In an environment where the carry cost and funding yield still clearly favor the US dollar, the yen struggles to gain substantial appreciation momentum.
Since the June FOMC meeting, the market's repricing of Fed policy expectations has been particularly intense. Federal funds futures indicate the market has priced in approximately 48 basis points of cumulative Fed rate hikes by mid-next year. Against this backdrop, the two-year US-Japan government bond yield spread has widened to over 280 basis points, reaching its highest level since the outbreak of the current Middle East conflict. Simultaneously, the correlation between USD/JPY and this yield spread is rapidly strengthening, suggesting the exchange rate is returning to the classic anchoring logic of interest rate parity.
Concurrently, the Bank of Japan announced it would maintain its monthly government bond purchases at about 2 trillion yen starting April 2027, pausing its previous plan to reduce purchases. The market widely views this move as dovish in tone. Analysts point out that under the strategy of "taking one step forward on rates, half a step back on balance sheet operations," continued balance sheet expansion implies the supply of yen is still increasing, fundamentally suppressing upward momentum for the exchange rate.
Ales Koutny of Vanguard, during a period of yen appreciation following Japanese intervention, actually increased long US dollar positions. He believes the Bank of Japan's pace of hiking rates approximately every six months "cannot effectively support the yen" and predicts the yen could fall to the 170 per dollar level.
Intervention Remains a Key Policy Tool, But Effectiveness Faces Tests
Citigroup believes that if global investors continue to favor risk assets, the Bank of Japan's policy normalization may be insufficient to offset periods of yen weakness. Therefore, intervention by Japanese authorities through buying yen remains an important tool for maintaining currency stability. Indeed, authorities have already taken action. Japan's Ministry of Finance confirmed last week that funds used for foreign exchange intervention reached a record 11.73 trillion yen (approximately $73.4 billion) as of May 27. Japan's holdings of foreign securities decreased by $75.6 billion compared to April, a decline roughly equivalent to the recent intervention amount, suggesting Japan may have financed the intervention by selling US Treasuries.
However, the market remains skeptical about the effectiveness of intervention measures. Current USD/JPY trading above 160 is within the "known intervention zone," a level that has historically triggered Ministry of Finance entry orders multiple times. Japanese Finance Minister Shunichi Suzuki stated publicly on Friday that the government is "ready to take bold action at any time" against excessive speculation in the currency market. This remark briefly provided support for the yen, pushing USD/JPY below 161, but the pair quickly rebounded.
Citigroup sets the long-term upper limit for USD/JPY around 160 and expects the exchange rate to experience a correction in the second half of this year. Analysts note that current short yen positions appear excessively large, and sustained rate hikes by the Bank of Japan could provide support for the yen. In the current low-volatility environment, hedging by purchasing yen may appear attractive.
Diverging Forecasts: 155 or 170?
Citigroup's 155 forecast is not the market consensus but falls within a relatively optimistic range. The median forecast from about 40 securities firms compiled by the London Stock Exchange Group shows an exchange rate of 154 yen per US dollar by the end of 2026—roughly aligned with Citigroup's prediction. However, market participants have not reacted positively to this forecast. Foreign exchange strategists at Bank of America, after meeting with investors, concluded: "European investors largely have no appetite to start buying yen again."
More aggressive bears point to 170. Vanguard's Koutny believes that, given the Bank of Japan's pace of hiking rates approximately every six months, "such a pace of rate hikes cannot effectively support the yen," and the yen could fall to the 170 per dollar level.
Whether Citigroup's assessment materializes depends on the fulfillment of three premises: whether the US-Japan interest rate differential shows a trend of narrowing, whether the outperformance of Japanese equities fades, and whether the Bank of Japan's policy communication can effectively guide market expectations. Against the backdrop of ongoing US-Iran tensions and renewed closures of the Strait of Hormuz, all three premises face a high degree of uncertainty.
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