USD/JPY Could Drop 10% if Fed Cuts Rates—Morgan Stanley's 2026 Yen Forecast

According to analysis from Morgan Stanley strategists, the Japanese yen may experience substantial appreciation relative to the dollar should the Federal Reserve proceed with interest rate reductions in response to economic slowdown signals. Strategist Matthew Hornbach and his team project that the yen interest rate differential could be a critical factor driving currency movement in the near term.

The Exchange Rate Disconnect

Currently, the USD/JPY pair trades at levels disconnected from fundamental valuations. Morgan Stanley’s research suggests this misalignment stems partly from how the yen interest rate environment compares to US Treasury yield dynamics. As the spread between American and Japanese rates narrows through Fed rate cuts, the mathematical driver supporting dollar strength dissipates. The strategists note that declining US Treasury yields would compress the interest rate arbitrage opportunity, traditionally one of the pillars supporting USD/JPY levels.

Timeline and Targets

The firm’s base case projects USD/JPY to deteriorate toward 140 during the first quarter of 2026, representing approximately 10% depreciation from current levels. This assumes the Fed follows through on multiple rate reductions amid visible economic deceleration. The yen interest rate environment, while unlikely to shift dramatically, would become relatively more attractive as the dollar-denominated fixed income returns compress.

By the final quarter of 2026, Morgan Stanley expects a partial recovery toward 147 as American economic growth rebounds and carry trade demand resurfaces. This cyclical pattern reflects expectations that looser Fed policy in early 2026 will eventually give way to a stronger growth backdrop.

Policy Constraints

Japan’s fiscal position remains constrained, limiting government stimulus as an offsetting force to yen appreciation. This structural backdrop means currency movements will remain primarily driven by Fed policy shifts and the yen interest rate outlook rather than coordinated stimulus measures. The absence of aggressive fiscal expansion in Tokyo leaves the yen interest rate dynamics as the primary transmission mechanism for policy-driven currency shifts.

As capital flows respond to rate differentials and economic cycle positioning, strategists anticipate cyclical pressure on dollar-yen before conditions stabilize later in the year.