William Pesek
TOKYO — If you want to know how worried Asian officials are over a sliding US dollar this year, look no further than the frantic scene at Bank of Japan (BOJ) headquarters.
For at least five days now, BOJ Governor Haruhiko Kuroda’s team has been making massive unscheduled bond purchases. The reason: the yen’s surge in the two weeks since Kuroda announced a widening of the range in which the 10-year yield can trade to about 0.5% from 0.25%.
For the BOJ, it was the monetary equivalent of opening a can of worms. The December 20 shift aimed to reduce strains as US and Japanese rates pulled in diverging directions.
But Kuroda leaned into an already sliding dollar amid US recession fears. Now the BOJ is struggling to keep the yen from rallying too much, too fast and slamming Japan’s exporters.
It’s a preview of the year to come for Asia. “The table is set for continued dollar weakness,” says Michael Purves, chief executive officer at Tallbacken Capital Advisors.
From Beijing to Jakarta, 2023 is looking like the flip side of 2022. Over the last 12 months, the region dealt with the fallout from the dollar’s 8% trade-weighted rise that siphoned tidal waves of capital from markets everywhere. Driven by the most aggressive US Federal Reserve tightening in 27 years, the dynamic caused extreme volatility in currency and asset values.
Now, it’s time for Asia to brace for a falling dollar, a perhaps chaotic downward move that has global investors pivoting to an even more aggressive “risk-off” crouch.
The big worry is that investors have at least four good rationales to dump dollars. One is the fast-rising odds of negative US growth this year. Two, the worst inflation in 40 years that will probably prove stickier than markets believe. Three, an unsustainable national debt rising toward US$32 trillion. Four, toxic partisanship on a level Capitol Hill not seen in a dozen years.
This quadruple whammy of internal risks is colliding with a gloomy external scene. China’s Covid reopening gambit remains wildly uncertain, with Beijing’s Covid case tolerance veering from zero to 100 at bewildering speed.
Demonstrators protesting against strict Covid measures in the capital Beijing before the government pivoted to reopening. Image: Screengrab / RNZ
Yet speed doesn’t equal success. Surging infection rates will test Communist Party leader Xi Jinping’s mettle as rarely before. Even if Xi can resist pressure to revert to lockdown mode, the volatility to come for Chinese gross domestic product (GDP) will dominate Asian markets in 2023.
And it’s not just the risk of big policy zigs and zags in Beijing that are cause for alarm. On the one hand, chaos from big Covid outbreaks could create fresh uncertainty about Chinese factory operations and, by extension, new trouble for global supply chains. On the other, booming Chinese demand could exacerbate global inflation pressures.
Economist Chris Turner at ING Bank says that “investors will continue to focus on China as a potential engine of growth in 2023, but for the time being, we have yet to see any material outperformance of the Chinese renminbi or local equity markets.”
This, Turner adds, “suggests that the risk of a disorderly exit from ‘zero-Covid’ policies for the time being trumps the reopening story and perhaps Beijing’s re-orientation to growth policies. That leaves the market to focus on the tighter monetary policy being implemented around the world.”
Meantime, Europe’s inflation troubles will remain acute.Energy market dynamics are expected to be just as challenging as in 2022 as Russia doubles down on its Ukraine invasion, leaving the continent less competitive.
“We expect the euro area to go into a mild recession by year-end and GDP to contract by 0.5% in 2023,” says strategist Eoin O’Callaghan at Wellington Management.
The problem, he explains, is a “sharp squeeze in households’ real incomes and firms’ margins has pushed sentiment to the lowest levels since the 2008/09 global financial crisis.”
ING’s Turner adds that the recent “hawkish shift from the European Central Bank has dented eurozone and global growth prospects for 2023 and leaves the dollar in a rather mixed position. On the one hand, the ECB wants tighter monetary conditions, including a stronger euro. On the other, the Federal Reserve is not done with its tightening cycle and a global slowdown typically is not a good story for a pro-cyclical currency like the euro.”
Japan is struggling to fend off its own recession at the same time Asia’s No 2 economy suffers near 4% inflation for the first time in decades. Count Marcel Thieliant at Capital Economics among those who think “the Japanese economy will enter a recession sometime” this year.
Hence the BOJ’s urgent effort to cap exchange rates so as not to kill the all-important export engine. There may indeed be natural limits to how much the yen rises. “Japan’s trade balance, now in the red, is unlikely to improve, limiting the upside of the yen,” says analyst Teppei Ino at MUFG Bank.
Yet as Kuroda is learning before his retirement in March, dollar-yen dynamics going forward owe more to investors’ perceptions about Washington’s finances and politics. This will surely be the case, too, for whomever Prime Minister Fumio Kishida chooses as the BOJ’s next leader.
Federal Reserve chairman Jerome Powell is in the hot seat. Photo: Pool
US Fed Chair Jerome Powell hasn’t yet signaled an end to the most aggressive US tightening since the 1994-95 period. But leading economic indicators suggest the US is ripe for at least a moderate downturn.
It could be ripe, too, for the biggest market stumbles since the 2008-09 Lehman Brothers-induced global economic crisis. Only this time, it might come with a side order of surging inflation.
“The US is in recession by any definition,” explains Scion Asset Management founder Michael Burry, who actor Christian Bale portrayed in the 2015 film The Big Short. The “Fed will cut and government will stimulate. And we will have another inflation spike.”
Hopes US inflation already peaked enabled the US Treasury bond market to register its strongest start of any year since 2001. So far, 10-year yields have fallen about 15 basis points to 3.74%.
One snag, though: the 2001 rally was driven by expectations that then-Fed chairman Alan Greenspan would be slashing interest rates amid stable-to-weaker consumer price trends. That expectation isn’t a live one at this moment given the galaxy of moving parts driving Fed decision-making.
What’s more, 2023 is likely to be “tougher than the year we leave behind,” International Monetary Fund managing director Kristalina Georgieva recently told CBS News. “Why? Because the three big economies – the US, EU and China – are all slowing down simultaneously.”
The IMF’s China take is that the overhang from Xi’s strategy of locking down entire metropolises — tens of millions of people at a time — will act as a drag on GDP for some time. So will exploding Covid cases across a nation that until now has relied on subpar vaccines.
Georgieva adds that “we expect one-third of the world economy to be in recession. Even countries that are not in recession, it would feel like a recession for hundreds of millions of people.”
The cumulative effect of aggressive Fed rate hikes also will act as a drag. With a pro-Donald Trump faction of Republicans now holding the House of Representatives’ gavel, attacks on Fed independence are likely to come early and often. That’s unlikely to sit well with global investors or Asian central banks sitting on large dollar holdings.
Trumpian attacks on institutions raise concerns about whether Republicans might again play politics with the US debt ceiling. The last time that happened, in 2011, House Republicans threatened to let the US default on its debt if Democrats refused massive social spending cuts. S&P Global reacted by stripping Washington of its AAA credit rating.
Might it happen again in 2023? On his annual list of top-10 risks for the new year, Eurasia Group CEO Ian Bremmer includes the “Divided States of America.”
As Bremmer puts it, “the 2022 midterm elections halted the slide toward a constitutional crisis at the next US presidential election as voters rejected virtually all candidates running for state governor or state attorney general who denied or questioned the legitimacy of the 2020 presidential election.”
But, he adds, “the US remains one of the most politically polarized and dysfunctional of the world’s advanced industrial democracies heading into 2023. Extreme policy divergences between red and blue states will make it harder for US and foreign companies to treat the United States as a single coherent market, despite obvious economic strengths. And the risk of political violence remains high.”
A pro-Trump protester in front of Capitol Hill. Photo: AFP via Zuma / Joel Marklund
That would be dollar-negative. So would volatility in markets if Congress draws the ire of analysts at S&P, Moody’s Investors Service or Fitch Ratings. Already, there are clear signs Washington’s top holders of US Treasuries — Japan and China — are reducing their exposure to the dollar.
The worry for officials at the BOJ and the People’s Bank of China is that the dollar is at risk no matter what the Fed does. On the one hand, “recessionary worries are going to drive the Fed to pause — this is why the dollar is weakening here,” says analyst Edward Moya at OANDA.
On January 4, the Bank of Korea announced that Seoul’s overall foreign-exchange reserves are expanding apace as the sliding dollar converts into increases in the rest of its currency portfolio. At the end of December, South Korean reserves totaled $423.16 billion, up $7.06 billion from November.
A big acceleration in dollar losses, though, would have officials from Seoul to Singapore scrambling. That’s a serious risk as an acceleration in inflation from the current 7% rate could tip the US toward stagflation. “If you’re an investor, you need to play off expectations as much as reality,” says Brad McMillan, chief investment officer at Commonwealth Financial Network.
Economist Louis-Vincent Gave at Gavekal Research thinks markets in 2023 will be asking the difficult questions of the globe’s biggest economy for which investors lacked enough bandwidth to weigh in recent years.
“In the absence of a recession, over the next few years the US will be running twin deficits totaling 8-10% of GDP,” Gave explains. “Who will fund these deficits? If it is to be foreigners, the US dollar will stay strong and US interest rates will remain relatively stable. But what if the numbers start to get too large for foreign buyers?”
Or more likely, Gave says, “what if the foreigners on the other side of the US deficits, including China and Saudi Arabia, no longer feel as confident deploying capital in the US? In either case, the deficits will have to be funded either by the resumption of quantitative easing by the Fed, or by a surge in treasury purchases by US commercial banks. Either of these would be negative for long yields and the US dollar.”
This view scratches at perhaps the biggest wildcard for 2023: how geopolitical megatrends play out.
It’s well understood how Xi’s PBOC has been working to internationalize the yuan and transform Beijing into the global lender of last resort. Yet when considered in the context of monetary, fiscal and political dislocations preoccupying Washington, all indications are that “de-dollarization is about to accelerate from here,” economist Zoltan Pozsar at Credit Suisse writes in a December 29 report.
China wants its currency to replace the dollar in international affairs – but it’s not that simple. Image: iStock
Pozsar wonders “what are G7 policymakers, rates traders, and strategists to do when threats to the unipolar world order are coming from every angle? They should definitely not ignore the threats, but they still do.”
For two generations, Pozsar continues, “we did not have to discount geopolitical risks. Since the end of WWII, the only Great Power conflict investors really had to deal with was the Cold War, and since the conclusion of the Cold War, the world enjoyed a unipolar moment: the US was the undisputed hegemon, globalization was the economic order and the US dollar was the currency of choice.”
Today, though, Pozsar continues, “geopolitics has reared its ugly head again: for the first time since WWII, there is a formidable challenger to the existing world order, and for the first time in its young history, the US is facing off against an economically equal or, by some measures, superior adversary.”
China, Pozsar notes, is “proactively writing a new set of rules as it replays the ‘Great Game,’ creating a new type of globalization” via newish institutions like the Belt and Road Initiative, BRICS+, and the Shanghai Cooperation Organization.
Whether this bipolar or multipolar world comes into clearer view in 2023 is anyone’s guess. What’s not debatable is that a series of daunting dilemmas are converging to make the year ahead uniquely challenging for Washington and the dollar. And all this puts Asia directly in harm’s way.
Follow William Pesek on Twitter at @WilliamPesek
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