Foreign Exchange Commentary

Summary

• Canadian dollar trims loss as oil prices advance.
• The widely watched 10-year U.S. Treasury yield rises to fresh 2024 high above 4.42% at peak.
• U.S. dollar drops to session low post ISM data; Japanese yen nears 2024 low.
• Fewer Federal Reserve interest rate cuts forecasted for 2024.
• Strong ADP data weighs on Treasuries as USD/JPY resumes climb.
• Japanese yen weakens a bit further after BoJ operation, earthquake in Taiwan last night.
• AUDGBP seen at 0.55 by yearend on rate differential: Westpac.
• Mexico peso drops ahead of Powell, swaps rise.
• U.K. pound drifts near six-week low, gilts little changed.
• MUFG trims pound forecast; sees earlier start to Bank of England rate cuts.
• Indian rupee falls to record closing low against dollar.
• China’s yuan nears weak end of PBOC’s trading band.
• EIA: Crude +3,210k Bbl, median estimate -1,000 Bbl.

Noteworthy

• The Yen’s Fall Could Spark a New Currency War with China 

If the Bank of Japan thought it was making a big "goodbye zero interest rates" statement last month, the yen sure hasn’t noticed.

The currency has dropped about 1.6% versus the dollar since the BoJ ended its negative-yield regime, boosting benchmark rates to 0.1% from -0.1%. The yen’s decline since then is hardly a game-changer, but it smacks of investor defiance.

BoJ Governor Kazuo Ueda’s March 19 statement signaled an end to 25 years of free money. BoJ officials and financiers had feared this moment, believing it would violently upend markets as the yen skyrocketed. The yen, after all, is the premier funder of “carry” trades everywhere.

Instead, crickets in trading pits. There are many takeaways from the yen’s continued test of 1990 lows, a dynamic that has Finance Minister Shunichi Suzuki threatening intervention.

One is that traders think the risk averse BoJ is still all bark and no bite. The last time the BoJ tried to “normalize” policy in 2006-2007, it quickly reverted to zero. And myriad times over the last decade, as growth returned, it stuck with quantitative easing, leaving the BoJ with credibility problems. Another: Japan’s economic and fiscal realities make now a precarious moment for rate normalization amid rising recession risks.

But here is one upshot that requires much greater attention: how Japan’s policy turnaround lands in Beijing, where Chinese leader Xi Jinping is watching prospects for Asia’s biggest economy go from bad to worse.

As 2024 unfolds, Xi’s Communist Party may already regret setting China up for failure by announcing a 5% growth target. China’s property crisis continues to deepen, denting business and household confidence. Deflationary pressures are mounting as local government finances deteriorate. Youth unemployment is at record highs.

Nothing would add an economic tailwind to the mix faster than a weaker Chinese exchange rate. The yen’s drop, a dynamic that’s drawing zero outrage from the West, could give Xi the cover he believes he needs to drive the yuan lower.

Yet such a gambit would indeed shoulder check world markets and quickly become a geopolitical flashpoint.

Foreign exchange circles got a taste of this risk on March 22 when the People’s Bank of China suddenly loosened its vice-like grip on the yuan. Its decision to set the weakest daily yuan “fixing” rate in more than two months sent it tumbling to the weak side of the psychologically important 7.2 per dollar level.

Since then, authorities have kept speculators guessing. But PBOC Governor Pan Gongsheng knows his team doesn’t provide currency guidance in a vacuum. The chatter in Beijing is that Xi’s inner circle is losing tolerance with Japan’s beggar-thy-neighbor ways of boosting growth, and with minimal blowback from a Washington establishment spoiling for a China fight.

Count the ways a shift downward for the yuan might backfire, particularly as a contentious U.S. election cycle heats up.

Nothing might put President Joe Biden’s Democrats and Republicans loyal to Former President Donald Trump on the same page faster than a falling yuan. Look no further than the rare outpouring of bipartisan energy to clamp down on Byte Dance-owned TikTok.

Any sense in Washington that China is pivoting back to currency “manipulator” mode would immediately raise the political temperature. And not just from the Trump camp, but also Biden’s Treasury Department.

Trump has garnered considerable attention with plans for a 60% tariff on Chinese goods and revoking Beijing’s “most favored nation” status should he be elected again. This would surely trigger a bull market in retaliatory gestures across the Pacific.

Odds are, Biden’s White House also would seek to buttress its tough-on-China bona fides. In recent weeks, Treasury Secretary Janet Yellen chastised Beijing for ramping up state-subsidized production of electric vehicles, lithium-ion batteries, and solar energy.

To date, Biden has scored some big wins versus China. He limited its access to semiconductors and other vital technology. He brought rivals Japan and South Korea together to close ranks vis-a-vis-China. He’s invested hundreds of billions of dollars in rebuilding tech muscle at home. Meanwhile, Trump’s 1980s-style tariffs irked China but did little to get America into better economic shape.

Yet the race to the bottom with which Japan is flirting could provoke other Asian nations, too. Korea, the region’s No. four economy, could use a pick-me-up via a weaker won as manufacturing activity contracts. Singapore could use a similar exchange-rate-driven boost as domestic demand flatlines.

The Southeast Asian economies at the center of the 1997-1998 financial crisis are also looking on warily. Neither Indonesia nor Thailand would be able to sit by if Beijing followed Tokyo’s lead on exchange rates.

In Jakarta, Indonesian President-elect Prabowo Subianto’s pledge to generate 8% growth is inspiring lots of eye-rolling. Even matching 2023’s 5.05% growth over the next few years seems a reach as global prospects dim. Things are even more uncertain in Thailand, which the World Bank sees growing 2.8% at best. 

The Federal Reserve’s reluctance to ease is also a blow to Asia in 2024. As the year opened, officials from Tokyo to Kuala Lumpur assumed several U.S. rate cuts were a given. As stubbornly high inflation leaves Fed Chairman Jerome Powell’s team gun-shy, Asia’s economic calculus is changing.

The same goes for the risk of China joining a new currency war that would leave Washington in an awkward place. Blaming rival China, when staunch U.S. ally Japan started the currency war, would be a difficult position.

If “Japan is back,” as foreign investors rushing into Nikkei 225 Stock Average stocks proclaim, shouldn’t the BoJ be normalizing rates in ways yen traders notice? It’s high time Tokyo took off the training wheels and grew its economy the organic way.

Though Japan has pursued a weak yen for a quarter-century, it turbocharged things over the last decade in ways now backfiring on the economy. It took the onus off government after government to cut bureaucracy, internationalize labor markets, catalyze a startup boom, and empower women. It reduced the urgency for corporate CEOs to innovate, restructure, and take risks.

Now, an undervalued yen may tempt China to join the fray in ways that could give Democrats and Republicans common cause to escalate Sino-U.S. tensions to new heights. The only thing that’s clear between now and the Nov. 5^th election is the need to buckle those seat belts.