[Comprehensive Guide] Global Investment Strategy in a World with Interest Rates: The Truth About Exchange Rates and the Optimal Asset Allocation Brought by the 'Resurgence' of …

The era of unprecedented monetary easing and zero-interest-rate policies has come to an end, and the global economy, led by Japan and the United States, has completely shifted toward a ‘world with interest rates’.

However, for Japanese investors who have long been accustomed to deflation and zero interest rates, this new phase brings numerous questions and confusion. Points such as ‘Why isn’t the yen strengthening as much as expected even though the interest rate gap between Japan and the U.S. is narrowing?’, ‘Will rising interest rates deal a blow to households and Japanese companies?’, and ‘What is the significance of bond investment in an inflationary phase?’ are exactly the issues that many market participants are currently facing.

In this article, we will systematically organize everything from structural changes in the macroeconomy to the dynamics of the foreign exchange market, and even practical asset allocation strategies in the phase of interest rate revival, to uncover the essentials that individual investors should grasp.

1. The Currency Paradox: Why didn’t the ‘narrowing of the Japan-U.S. interest rate gap’ lead to a stronger yen?

When practicing global investment, the outlook for the exchange rate is unavoidable. It is generally explained that ‘money flows from low-interest currencies to high-interest currencies, so if the interest rate gap narrows, the yen will strengthen.’ However, looking back at recent market trends, a phenomenon is occurring that cannot be explained by this textbook logic alone.

Limits of interest rate gap theory and structural yen selling due to the new NISA

Since 2025, due to intermittent interest rate cuts by the U.S. Federal Reserve (FRB) and interest rate hikes by the Bank of Japan, the policy interest rate gap and long-term interest rate gap between Japan and the U.S. have steadily followed a narrowing trend. Many market participants predicted a ‘rapid appreciation of the yen accompanying the narrowing of the interest rate gap,’ but the actual exchange rate remained at a weak yen level centered around the 150 yen range for a long time, betraying market expectations.

Why has the powerful indicator of the interest rate gap stopped working? One reason cited is the outflow of funds based on real demand, especially the structural changes accompanying the penetration of the new NISA.

Since the start of the system, individual foreign securities investment via investment trusts (investment in foreign stock funds represented by All Country or S&P 500, etc.) has continued to generate a constant outflow of approximately 10 trillion yen per year. This is a flow that mechanically sells yen and buys foreign currency every month, and it continues regardless of how the short-term interest rate gap between Japan and the U.S. moves. The ‘structural real-demand yen selling’ that traditional macroeconomic theory did not anticipate is strongly offsetting the yen appreciation pressure caused by the narrowing interest rate gap.

The true primary factor moving exchange rates is the absolute level of ‘U.S. long-term interest rates’

While the correlation of the interest rate gap has collapsed, what still shows an extremely high correlation with the dollar-yen exchange rate is the ‘absolute level of U.S. long-term interest rates (10-year Treasury yield)’.

Looking back at the history of the weak yen over the past few years, the most rapid dollar appreciation and yen depreciation occurred during the phase when the U.S. rapidly raised its policy interest rate from zero to over 5%. Since this surge that broke through from around 110 yen to 150 yen to the dollar, the dollar-yen rate has moved in parallel with the trend of U.S. long-term interest rates. The view that the dollar-yen is also stuck in a high range precisely because U.S. long-term interest rates are stuck at a high level in the 4% range best matches the reality.

Rather than looking at Japan’s monetary policy alone or the difference between Japan and the U.S., determining the level of long-term interest rates in the United States, the world’s largest reserve currency country, is the deciding factor in grasping the trend of exchange rates.

Future range forecast for U.S. long-term interest rates and dollar-yen

So, what trajectory will U.S. long-term interest rates follow in the future? When breaking down the ‘expected inflation rate’ and ‘real interest rate’ that are the components of long-term interest rates, the key to the future is the underlying trend of prices.

In U.S. inflation, service prices (especially core services excluding rent), which account for the largest weight, are showing a clear settling down as the labor market softens and wage growth slows. On the other hand, supply-side factors such as tariff policies, energy prices including crude oil, and rising material prices accompanying AI and semiconductor demand remain as factors hindering the downward pressure on prices.

If crude oil prices stabilize and inflation cooling is confirmed, it is highly likely that U.S. long-term interest rates will gradually fall to a level below 4%. In that case, the main scenario is that the dollar-yen exchange rate will also fall below 150 yen and return to a moderate yen appreciation trend toward the 140 yen range.

However, it is also necessary to pay attention to the risk that if concerns about a U.S. economic recession emerge rapidly, there is a risk that a rapid appreciation of the yen will proceed along with a sharp drop in U.S. interest rates, as in past phases.

2. The reality of the Japanese economy and corporate behavior brought about by the revival of interest rates

Turning our eyes to Japan, with the raising of policy interest rates and the rise of long-term interest rates to around 3%, a ‘normal world where interest rates exist’ has returned for the first time in over a decade. This change is fundamentally rewriting the behavioral patterns of domestic households and companies.

Household Balance Sheets: Macro Benefits and Micro Fragility

When we hear about rising interest rates, the focus tends to be on the negative aspects, such as hikes in mortgage rates and increased interest payment burdens. However, when looking at the household balance sheet of Japan as a whole from a macro perspective, a different picture emerges.

The financial assets held by Japanese households significantly exceed their liabilities (such as mortgages), resulting in a massive surplus on a net asset basis. Rising interest rates mean an increase in interest income earned from savings, government bonds, etc., which acts to boost household income for the macroeconomy as a whole.

Of course, disparities based on age group and asset holdings must be considered. While younger generations with large variable-rate loans may face cash flow pressure, middle-aged and older generations who have accumulated assets will benefit from increased interest income.

Even more important is the fact that in a rising interest rate environment, wage growth and increases in stock and real estate prices are occurring in parallel. Since both asset prices and nominal income are expanding, households with a sound financial foundation do not need to overly fear the negative impact of rising interest rates alone.

What should be guarded against are localized cases of excessive debt, such as those who, assuming that low interest rates would last forever, dabbled in one-room apartment investments with full leverage beyond their means. Investment models that did not factor in the risk of rising interest rate costs will be rapidly weeded out from here on.

The Pitfalls Lurking in Personal ‘Yen Carry Trades’

Another dangerous trend created by the distortion of the interest rate environment is leveraged investment utilizing ‘securities-backed loans,’ which has spread among wealthy individuals and retail investors.

The method of borrowing in low-interest yen (or Swiss francs) and investing those funds in high-yield assets denominated in US dollars is nothing more than a personal version of the ‘yen carry trade.’ Since US dollar-denominated borrowing rates remain high, procurement is being conducted across currencies to capture the interest rate spread, but this carries inherent, significant foreign exchange and liquidity risks.

Foreign exchange markets are a zero-sum world where, over a medium- to long-term span of 5 or 10 years, reversals occur due to purchasing power parity and economic cycles. Just as the rate once changed drastically from the 70 yen range to the 150 yen range against the dollar, there is no guarantee that the exact opposite of current common sense will not occur in the next 10 years. Leveraged trades based on the simplistic assumption that ‘yen interest rates will not rise’ or ‘foreign exchange will not move from the current weak yen level’ always carry the danger of suffering painful reversals during sudden fluctuations in exchange rates.

Mild Inflation Stimulates Corporate Capital Investment

On the corporate side, rising interest rates mean increased funding costs, so at first glance, it seems like a factor for shrinking capital investment. However, the reality of the real economy is the opposite.

The biggest problem during the past deflationary period was that even if companies conducted massive research and development or capital investment, they would get caught up in a price-cutting war for their products, making it impossible to turn a profit. As a result, the internal rate of return (IRR) for investment plans did not meet the criteria, and investments continued to be passed over.

In the current inflationary environment, companies have become able to pass on cost increases and create business plans that anticipate price hikes of several percent per year. Because nominal sales and future cash flows are expanding due to inflation, it has become easier for projects to be profitable even after deducting the rise in interest costs. Moderate inflation and the accompanying rise in nominal interest rates are not dampening corporate appetite for capital investment; rather, they are beginning to function as a powerful engine that justifies long-term growth investment.

3. Portfolio Strategy in a World with Interest Rates: The ‘Resurgence’ of Bonds and the Winning Path for Individuals

With the macro environment and corporate behavior changing drastically, what kind of asset allocation should individual investors build? The biggest theme is the ‘resurgence of bonds,’ which had long been excluded from the leading role in portfolios.

The End of ‘Stocks Only’ and the Revival of the Bond Option

In the era of ultra-low interest rates, when long-term interest rates were stuck around zero percent, the return on risk-free assets like government bonds was effectively zero. To prevent the decline in purchasing power due to inflation and to earn returns, there was a structure that forced investors to choose ‘taking risks and going all-in on stocks (100% stocks).’

However, now that interest rate levels have risen both domestically and internationally, this composition has changed dramatically. By incorporating long-term government bonds and high-quality corporate bonds, it has become possible to secure stable income gains, and an environment has been prepared where portfolio rebalancing (such as the traditional diversified investment of 60% stocks and 40% bonds) functions effectively once again.

The very fact that it has become possible to selectively use time periods to pursue capital gains from stocks and time periods to enjoy income gains from bonds while suppressing volatility is a significant step forward for investors.

Bonds as ‘Defensive Assets’ and the Counterproductive Pursuit of Yield

There is a principle to keep in mind when incorporating bond investments. That is, ‘bonds are not assets for directly hedging against inflation.’ It is fundamentally difficult to overcome high inflation with only the fixed coupon income earned from bonds, and the primary drivers for asset growth and inflation hedging are, ultimately, stocks.

The essential role of bonds lies in smoothing out the price fluctuations (volatility) of the entire portfolio and providing a stable cash flow.

A trap that many investors fall into here is the behavior of seeking excessive yields from bonds. In the pursuit of high yields, if one invests too much capital into ultra-long-term bonds (high-duration bonds) with maturities exceeding 30 years or high-yield bonds with low credit ratings, the price decline associated with interest rate fluctuations will jump to levels comparable to stocks.

In a phase of monetary tightening, holding bonds that have maximized price fluctuation risk is synonymous with abandoning their role as ‘defensive assets.’ If you prioritize the stability of your portfolio, it is essential to appropriately control duration (interest rate sensitivity) and maintain a stance of not taking on excessive risk.

Exploiting the Difference from Institutional Investors: The Individual Investor’s Greatest Weapon is ‘Cash’

In the field of asset management, the greatest structural advantage that individual investors have over institutional investors is the ‘freedom to continue holding cash.’

Institutional investors such as pension funds and life insurance companies are obligated by investment guidelines and regulations to keep funds allocated to the market at all times (full investment requirement). Therefore, even in phases where bond prices are expected to fall due to rising interest rates, they are constrained to continue holding certain bonds and endure unrealized losses.

In contrast, individual investors have no such constraints at all. If bond market yields are on an upward trend and further price declines are a concern, the choice to ‘wait in cash’ without forcing bond purchases is completely free. Once interest rates have risen sufficiently and yields have reached attractive levels, you can shift funds into bond ETFs or government bonds for individuals when the time is right.

Without blindly following the investment policies of others, aim for growth with stocks and solidify your defenses with cash and appropriate bonds. This flexibility is the most reliable investment strategy for surviving a volatile ‘world with interest rates.’

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Conclusion

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