For decades, Japan has been synonymous with ultra-low interest rates, making it a favorite funding currency for global carry traders. The idea of Japan having higher interest rates than the United States—thereby making JPY shorts a positive swap trade—sounds almost unthinkable. But as central banks worldwide shift policies in response to evolving economic conditions, could we be approaching a turning point?

Japan’s Interest Rate Landscape: A Historic Shift

Japan has been in a low-interest-rate environment since the late 1990s, driven by stagnant inflation and sluggish economic growth. The Bank of Japan (BoJ) adopted a negative interest rate policy (NIRP) in 2016, setting the benchmark rate at -0.1% to stimulate borrowing and investment. However, with inflation finally showing signs of persistence beyond transitory factors, the BoJ has begun unwinding its ultra-loose policy.

Recent rate hikes have brought Japan’s short-term interest rate to 0.5%, the highest in over 15 years. Policymakers, including BoJ board members, have hinted at further rate increases, with some suggesting that rates should rise to at least 1% in the latter half of 2025. The BoJ’s cautious approach is designed to ensure inflation remains stable while avoiding shocks to Japan’s heavily indebted economy.

The U.S. Interest Rate Cycle: A Slow Descent

On the other side of the Pacific, the U.S. Federal Reserve has been battling inflation with one of the most aggressive rate-hiking cycles in recent history. After pushing the federal funds rate above 5% in 2023, the Fed has now begun easing off the gas. However, policymakers have emphasized that rate cuts will be gradual and measured. Even with anticipated reductions, the Fed is unlikely to bring rates below 4% anytime soon.

The Fed’s cautious stance stems from persistent inflation risks and the need to maintain economic stability. As a result, while U.S. rates may decline, they are still expected to remain significantly higher than those in Japan.

Will JPY Shorts Ever Offer a Positive Carry?

For JPY shorts to become a positive swap trade, Japan’s interest rates must surpass those of the U.S.—or at least narrow the gap enough for carry traders to break even. Given current projections:

1. The BoJ is expected to raise rates gradually, potentially reaching 1% in the next year or two.
2. The Fed may cut rates, but they are unlikely to drop below 4% in the near future.

Even in the most optimistic scenario for Japan, it is highly improbable that its interest rates will exceed those of the U.S. anytime soon. The structural differences between the two economies—Japan’s persistent deflationary tendencies versus the U.S.’s strong labor market and inflationary pressures—suggest that the gap will remain.

Implications for Traders and Investors

• Carry Traders: The JPY carry trade will likely remain a negative swap trade, meaning shorting JPY will continue to incur funding costs rather than generate interest income.
• FX Market: If Japan continues raising rates while the U.S. holds steady or cuts gradually, the JPY could strengthen, reducing the appeal of shorting the currency.
• Bond Markets: Japanese government bonds (JGBs) may see higher yields, attracting foreign capital and further influencing the USD/JPY dynamic.

A Distant Possibility, But Not Impossible

For Japan to have higher interest rates than the U.S., either the BoJ would need to embark on an unexpectedly aggressive tightening cycle, or the Fed would need to slash rates much more than currently anticipated. While central bank policies can shift rapidly in response to economic shocks, the structural realities of Japan’s economy make a sustained period of higher rates highly unlikely.

For now, JPY shorts will remain a negative carry trade—but traders should keep a close eye on BoJ policy shifts, as even incremental moves can have outsized effects on global markets.