USD/JPY's Near-Term Trajectory: Central Bank Divergence and Carry Trade Pressures

The USD/JPY cross has long been a barometer of global monetary policy divergence, and the December 2025 central bank meetings have reinforced its volatility. With the Bank of Japan (BoJ) and the Federal Reserve (Fed) charting distinct paths-tightening and easing, respectively-the currency pair is poised for further movement. This analysis examines how policy splits and carry-trade dynamics are shaping the near-term outlook for USD/JPY.

Fed Policy Divergence: A Divided Path Forward

The Fed's December 2025 meeting underscored deep internal divisions, culminating in a 9-3 decision to cut the federal funds rate by 25 basis points to 3.50%-3.75%. While most policymakers supported the cut, two members opposed it outright, and one argued for a larger 50-basis-point reduction. Fed Chair Jerome Powell emphasized the need to "wait to see" how the economy evolves before committing to further cuts, with projections indicating only one additional rate reduction in 2026. This cautious approach reflects lingering uncertainty about inflation and growth, creating a policy environment that is neither fully accommodative nor restrictive.

BoJ's Cautious Tightening: A 30-Year High, But With Limits

In contrast, the BoJ signaled a tightening bias in its December 2025 meeting, raising the policy rate by 25 basis points to 0.75%, the highest level in 30 years. Several policymakers argued for continued rate hikes in 2026, citing the need to reach "neutral" levels. However, structural challenges such as Japan's low inflation and high debt-to-GDP ratio, along with a fragile labor market, limit the BoJ's ability to maintain aggressive tightening. Governor Kazuo Ueda's emphasis on data-dependent policy adjustments has kept the yen's upside potential constrained, allowing the yen carry trade to persist despite narrowing yield differentials.

Carry Trade Dynamics: Strain and Structural Risks

The yen carry trade, estimated at $500 billion in outstanding positions, is under increasing strain. While the BoJ's rate hike to 0.75% has narrowed the U.S.-Japan yield gap, the USD/JPY pair remains near 155.14, reflecting market skepticism about the yen's ability to rebound. Analysts warn of potential large-scale liquidation if the yen appreciates sharply in early 2026, as hedging costs rise and capital outflows to higher-yielding assets accelerate. Structural factors, including Japan's weak inflation anchoring and corporate reluctance to shift from deflationary mindsets, further erode the carry trade's traditional support.

Outlook: A Bearish Bias for the Yen in 2026

The USD/JPY's trajectory will likely hinge on the BoJ's policy path and the Fed's rate trajectory. With the Fed projecting only one rate cut in 2026 and the BoJ adopting a cautious tightening stance, the yield differential between the two economies is expected to narrow further. This dynamic, combined with Japan's structural economic challenges, suggests the yen could weaken to 160 per dollar or beyond by year-end. However, unexpected inflation persistence in Japan or a more aggressive Fed pivot could disrupt this bearish scenario.

Conclusion

Investors navigating the USD/JPY cross must contend with a complex interplay of central bank policy divergence and carry-trade fragility. The Fed's divided approach and the BoJ's constrained tightening create a backdrop where the yen's weakness is likely to persist. Yet, structural risks to the carry trade and evolving economic data could introduce volatility. Positioning for a continuation of the current trend, while hedging against sudden reversals, remains critical in this high-stakes environment.