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Exchange rates are dropping like dominos. The pound, yen, euro and renminbi all touched multiyear or multi-decade lows against the dollar in recent weeks. Each economy is facing its own challenges: the energy crisis in Europe, fiscal U-turns in the UK, macro headwinds in China or a zeal for zero interest rates in Japan. But all are facing a common foe in the relentlessly strong US currency.
Policymakers are already being forced to react. Japan intervened to support the yen last month. A week later the Bank of England returned to bond buying - temporarily it hopes - to stabilise UK bond markets and the pound. The European Central Bank is liable to come under renewed pressure to prevent another blow up in Italian and other peripheral euro zone debt yields. Even China, with its only partly liberalized capital account, is feeling the effects of the dollar’s tenacious rise.
We have been positive on the dollar due to the scale of the US Federal Reserve’s hawkishness on interest rates, but the current moves are looking disruptive and concern about their impact on global financial stability is growing. The question now is whether this fallout contributes eventually to the Fed blinking on the main source of dollar strength: ever higher US interest rates.
The pound recently moved to the centre of the storm, after the UK’s new government announced a highly expansionary fiscal package with unspecified sources of funding. A 7 per cent slide against the dollar and major sell-off in gilts sent shock waves through other markets and drove the Bank of England on 28 Sept. to launch surprise temporary purchases of long-dated UK government bonds “to restore orderly market conditions”.
While the bank promised to flip back to its programme of quantitative tightening within weeks, for now the jury is out on whether it has capped the worst of the volatility. In the meantime, the government has abandoned its plan to cut taxes for the highest earners, but questions on the future of the fiscal package, its inflationary consequences and funding have not gone away. With most of the measures still set to be pushed through, the likely inflationary boost will keep the BOE on a steep hiking trajectory, until damage to growth from higher mortgage rates offsets the benefits of taming inflation.
The Bank’s intervention in the long-dated gilt markets - again a partial policy U-turn - has eased pressure both for emergency rate hikes and on the exchange rate, but it is still unclear whether the monetary policy committee will be able to wait until its November meeting to deliver what we expect to be a jumbo hike of 100 basis points. On the other hand, the market is pricing in a terminal rate of 5.6 per cent by the end of 2023, up from 2.25 per cent now. We do not believe the economy or financial system can tolerate rates that high.
Yen not immune
The yen has weakened to levels that prompted Japan’s Ministry of Finance to intervene on Sept. 22 for the first time since the 1990s. The weak currency largely reflects Japan’s economic fundamentals and the MOF may slow but is unlikely to reverse the yen’s depreciation, as its forex reserves of $1.24 trillion are still relatively small versus the volume of global yen-denominated forex trades.
Japan’s weak economic outlook and relatively low inflation argue against policy tightening, with price increases the mildest among developed markets. While the BOJ has not signalled any intention to get onto a policy tightening path any time soon, given nearly universal central bank hawkishness out there, the pressure for it to do so is certainly growing. In this sense, the BOJ is the wild card in the pack. If it abandons its policy of yield curve control and negative policy rates in order to protect the devaluing yen, we think that brings a range of scenarios into play, including the possibility of globally coordinated action to halt the strength of the dollar.
It is hard to see any immediately positive story for the euro. The European Central Bank remains less hawkish on interest rates than the Fed. And the Russian war in Ukraine and related energy market dislocations continue to worsen the region’s energy problems and broader economic outlook.
The ECB is certainly watching the euro’s exchange rate, perhaps more attentively than in the past, given the scale of depreciation against the dollar that we have seen and the additional headaches on inflation that it might entail. Whereas previous falls in the euro were accompanied by growth-supporting gains for exporters, that balance has been worsened by the energy shock, all priced in dollars.
This leaves the bank between a rock and a hard place: raising rates to tame inflation might support the euro but would strangle growth further, while lagging behind the Fed and other major centrals banks may keep the exchange rate falling and reinforce inflation.
As the ECB hikes rates further, it may also encounter unintended consequences from tighter global and domestic policy and may be driven to intervene in the bond market if the transmission mechanism breaks or financial stability issues arise. Italy’s new right-wing government could also reignite the peripheral debt crisis and spur more intervention.
China’s different track
While the Fed, BOE and ECB are hiking and the BOJ stands pat (for now), China has moved in the opposite direction by cutting rates three times this year, sending nominal yields on Chinese government bonds below those on Treasuries for the first time in a decade. The resulting interest rate differentials in combination with diverging growth profiles (slowing China vs strong US) have since April put significant downward pressure on the renminbi vs the dollar.
The People’s Bank of China has taken steps to soften the depreciation, reducing the foreign-exchange reserve requirement ratio for banks and making it more expensive to short the renminbi in derivatives markets while issuing a verbal warning against currency speculation. It has also guided market expectations by setting stronger-than-anticipated fixing rates in the onshore market. But the effect has been to slow the slide in a managed fashion, not stop it, and the Chinese currency recently touched its weakest levels against the dollar since 2008.
Still, the pace at which the renminbi has depreciated against the dollar has been moderate compared to the weakening of other currencies like the yen, pound or euro. And on a trade-weighted basis, China’s currency looks relatively resilient: it fell about 3 per cent against the dollar in September in the onshore market but has been relatively steady against the currencies of its 23 other major trading partners.
However, while Chinese exporters may benefit from the renminbi’s weakness against the dollar, if overseas demand deteriorates meaningfully, exporters will suffer on a net basis. The demand uncertainty could outweigh the cost benefit.
In the bigger picture, the dollar’s strength is making it a more challenging balancing act for China to aim for the so-called ‘impossible trinity’, or exercising control over monetary policy, capital account flows, and exchange rates. Economists posit you can only control two of the three at any one time, and China has been pushing the envelope thanks to its large trade surplus, increasing the use of the renminbi as a global trading or reserve currency, and last but not least, leaning on its enormous foreign reserves. The recent downward movements in the renminbi suggest it is being allowed to adjust more on a market-driven basis, but we don’t think that’s a sign that larger outflows would follow or that a bigger paradigm shift is afoot.
EM steadier than expected
If the strong dollar has some developed markets behaving like emerging markets, how are the actual EMs positioned? The cost of funding is still rising, and that is very challenging for most. But there are markets that are better positioned.
Asian economies have been dipping into their foreign exchange reserves in an effort to soften the blow to currencies, but they still have ample firepower, especially when viewed against the context of past periods of financial stress. Most have built up stores of reserves several times greater than where they stood during the 2008 global financial crisis.
We think the pressure on reserves is likely to remain, but that most economies are better placed to ride it out. Overall, the external vulnerabilities for most Asian countries remain manageable. Indonesia and Malaysia, as net exporters of commodities, still enjoy current account surpluses, as do other traditional current account surplus countries such as China, Korea and Singapore. Even for countries with current account deficits, such as the Philippines, Thailand and India, the forex reserves buffer still looks healthy and the external debt exposures are manageable, which reduces external vulnerabilities.
Takeaways for investors: Don’t fight the Fed
For now, markets seem stuck in a negative spiral. With even government bonds failing to protect portfolios, the dollar is likely to remain relentlessly bid as the ultimate safe haven. This in turn worsens global economic fundamentals and sentiment, raising interest repayments for international dollar borrowers and worsening inflation costs for those relying on imported goods priced in USD.
Defensive positioning remains key until this vicious circle can be broken. Equities and credit still look vulnerable, not offering value relative to where real bond yields or global business surveys might imply.
The dollar itself, while expensive, still makes sense to hold as a portfolio hedge. It is worth being nimble, taking profits against currencies that have experienced sharp declines to oversold levels, and rotating into others that have been more resilient near-term, as the dollar rumbles on.
What could break this negative loop and bring about better conditions for global markets? Ultimately, this is an inflation problem, so inflation is the answer. We need signs that US inflation - particularly core inflation, stripping out food and energy - is peaking and returning to manageable levels. At that point, the Fed will start to turn one eye away from fighting inflation, and towards mitigating the carnage in global markets and economies caused by growth and currency shocks. Extreme dollar pricing, depressed equity valuations, and painfully high credit spreads will all start to mean-revert when the Fed becomes the market’s friend. Usually this comes much earlier in a downturn. But we are not there yet.