Twin peak for dollar-yen?
The US dollar has held its strength since the last Federal Reserve (Fed) interest rate hike. Given the resilience of the US economy, it’s hard to bet against the greenback. Europe’s growth rate is weaker, and the European Central Bank (ECB) might be becoming more dovish. The best bet against the dollar might be the Japanese yen. The weak yen means the dollar / yen rate is at multi-year highs, but a change in monetary policy is coming, and there is more guarded optimism about Japanese stocks. Is there a yen for the Japanese currency?
America, oh yeah!
The phrase “US exceptionalism” has been used frequently this year. It has been spoken about in the context of the outperformance of US equities relative to the rest of the world, and particularly in relation to the second quarter’s (Q2) rapid rise in technology stocks. This was fuelled by the excitement around generative artificial intelligence and the implications of its broader application for US technology companies. In the middle of the current earnings season, the growth rate for US companies in the S&P 500 index is estimated at 13% so far, compared to -7% for those Euro Stoxx listed companies that have reported. American companies appear to have navigated higher inflation, higher interest rates and domestic political uncertainty very well.
The US has also been seen to be exceptional in terms of the resilience of the economy in the face of a more than 500 basis points (bps) increase in overnight interest rates and a rise in borrowing costs across the economy. The 4.9% annualised increase in GDP in Q3 cannot be bettered as an example of economic resilience when many had been forecasting a recession by now. European economies, by contrast, appear to have been more negatively affected by higher interest rates. The most politically sensitive economic statistic of them all - the unemployment rate - remains close to a record low in the US. Americans have jobs, better wage growth, increased home and public equity wealth, and a stock of savings. This is truly exceptional.
Uncle Sam’s greenback
The country’s currency reflects this. The dollar is strong. The dollar index tracks its value against a basket of other developed economy currencies. It is up 3.2% since the beginning of the year and 7.1% above the low it reached in mid-July just before the last Fed rate hike. The dollar strengthened a lot in 2022 as the Fed led the way in pushing up rates. It reversed this as other central banks caught up but since the end of July it has had another surge higher. The “higher for longer” message from the Fed and the commensurate increase in long-term US dollar bond yields has benefitted the dollar. In spot terms, only the Swiss franc has performed better in 2023. In total return terms, the dollar is king amongst its peers.
Policy key to dollar outlook
The combination of tight monetary policy and loose fiscal policy is a classic bullish policy backdrop for a currency. As markets try to look forward, it is expectations around policy moves which will be important. For the moment, the Fed is not budging in terms of its message around interest rates. It needs to keep rates at a restrictive level to ensure inflation retreats towards target and inflationary expectations are re-anchored. So, ongoing tight monetary policy is a support for the dollar. Markets are not pricing in any change in interest rates until at least the middle of 2024. So, betting against the dollar in general does not look like a high-conviction strategy until there are changes in the perception of the interest rate outlook, and the strength of the US economy.
On the fiscal front, the bond market might be worried about large deficits and Treasury supply, but this is keeping yields high and, in turn, could be a support for the dollar. There is no sign of a meaningful reversal in US fiscal policy anytime soon. Indeed, ahead of the Presidential Election in November next year it is hard to imagine Washington promising massive spending cuts. This week’s auction of seven-year maturity US Treasury bonds, with a coupon of 4.9%, was very well received by investors. High yields are dollar positive.
ECB becoming more dovish?
The dollar’s recent strength reflects the spot interest rate differential over other major currencies, the strength of the Fed’s message about keeping rates high for long, and the greater resilience of the US economy relative to Europe. Hence, the dollar is trading at just above $1.05 to the euro and a re-test of the parity level is a potential scenario before year-end. The ECB kept rates unchanged at 4.0% on 26 October but there were signs of creeping dovishness in Christine Lagarde’s press conference. The rates market is starting to price in more chance of ECB rate cuts coming earlier than any from the Fed.
The one currency pair that is interesting is the dollar against the Japanese yen. It broke through the Y150 threshold this week, a level the market had identified as being something of a line in the sand for the Bank of Japan. The dollar touched the Y150 level last October so the current move marks something of a twin peak for the exchange rate. It has not been this high since 1998 and, before that, 1991 at the height of US-Japan trade tensions. Of course, in real terms the yen is not as weak as it was then because Japan has had cumulatively lower inflation over the years than has been the case in its major trading partners. However, the speed of the yen’s decline versus the dollar, the euro and the pound is quite something. Deutsche Bank provide estimates of trade-weighted currency valuations and the yen is at its lowest since the series began in 2000.
Mysteries of the East
Japan’s economy and markets are always a mystery. Since the real estate bubble burst in the early 1990s the economy has struggled with deflation, rising government debt, negative growth in the working age population and often incoherent policy decisions. Investors have tried on many occasions to call turning points – being long Japanese equities and short Japanese government bonds. On many occasions these trades have needed to be classified as “widow makers”. Over the past 30 years, the annualised total return from Japan’s equity market has been just 2.9% compared to 9.9% for the US market. Of course, there have been times when the market has done well but in local currency terms, returns from the Japanese stock market have only beaten US equity market returns in one out of four years since 1991.
Rising sun (yen?)
Yet there may be changes afoot. The Bank of Japan (BoJ) has been running an anti-deflationary monetary policy for years marked by negative overnight interest rates and a huge expansion of its balance sheet to fund bond purchases aimed at capping the yield on government bonds. According to Bloomberg data, the Bank of Japan’s balance sheet is equivalent to 130% of GDP (equivalent estimates for the US and Eurozone are 30% and 50%). There is going to be some change to all of this. The BoJ has signalled that its yield curve control (YCC) policy will be adapted at some point. This means, they will allow higher Japanese government bond yields. The yield on the benchmark 10-year bond has already risen to 88bps from 50bps in the first half of 2023 and 10bps-20bps for the period from 2016 to the end of last year. Overnight interest rates might not go up yet but yields across the maturity curve should move higher in the months ahead. The gap between US and European bonds versus Japanese bonds should narrow.
The driver of a change in monetary policy is that Japan has not been able to fully isolate itself from the rise in global inflation over the last two years. After being close to zero for years, consumer price inflation rose to 2.2% last year and is expected to average close to 3% in 2023. This is obviously much lower than in the US and Europe, and forecasts for 2024 and 2025 are also lower than in those economies. However, it is a substantial change for Japan. Not that there needs to be a massive tightening of policy but a shift towards more market setting of interest rates and an end to a ballooning central bank balance sheet seems appropriate.
A change to monetary policy – albeit a modest one – could help the yen. There is also more interest in Japanese equities again. Not necessarily because of the reasons that led investors to bet on Japan in the past. The authorities have been taking steps to make the workings of the Japanese market more efficient by encouraging reduced cross-shareholding and making listings more attractive to investors. Moreover, given the shifts in global supply chains, Japan could be seen as a diversifier for global equity investors given its potentially significant role in the technology supply chain. The Taiwan Semiconductor Manufacturing Company (TSMC) has already agreed to build a semiconductor fabricating unit in Japan. Toyota is leading in the way in the development of solid-state batteries for electronic vehicles. This would dramatically increase the range of vehicles and provide an alternative to lithium-based battery technology. Consensus estimates put Japanese earnings per share growth at 7% for 2024 and over 9% in 2025. On current 12-month earnings estimates, the Japanese market trades in around a 14-times price-to-earnings multiple. This is higher than European markets but compared to the level of interest rates in Japan, it suggests a much more attractive equity-risk premium.
I have not suddenly become bullish on Japan. However, seen through the eyes of the exchange rate, a stronger yen might be a decent trade in the coming months. A shift in monetary policy, a more positive structural view on Japanese equities, and Japan being part of the US-European western geopolitical alliance is important in how global supply chains evolve. To top it all, I am not sure the BoJ wants an even weaker currency given how it has already prevaricated over changing its domestic monetary stance. The currency is weak, and the balance of probabilities suggests that it will not get much weaker.
(Performance data/data sources: Refinitiv Datastream, Bloomberg 27 October 2023). Past performance should not be seen as a guide to future returns.