Looking at the world: the strong dollar is once again "making waves"

Finance Associated Press, March 27 (edited by Xiaoxiang) If you want to talk about the first quarter of this year, which country's financial market is the most eye-catching, then the answer is undoubtedly Japan - just last month, the Nikkei 225 index just broke the record of a 34-year historical high, and this week, the yen has also become the focus of the global financial media spotlight: the morning crash to a new low in nearly 34 years!

This scene will more or less make some foreign exchange traders feel incredible: the Bank of Japan just ended negative interest rates last week and announced a rate hike for the first time in 17 years, why did the yen quickly and further amplify the decline after the central bank raised interest rates?

The USDJPY briefly touched 151.97 in the early morning of the day, surpassing the 151.95 level that triggered direct foreign exchange intervention by the Bank of Japan in October 2022 and a level not touched by the pair since July 1990, according to market data.

The collapse of the yen has undoubtedly raised the risk of intervention by the Japanese authorities. But for now, perhaps the more pressing issues are:

What is causing this wave of Japanese market decline?

Is it true that the yen is the only one facing depreciation risks in the global foreign exchange market?

What does the sudden emergence of a strong dollar mean in a well-known Fed rate cut year?

Why did the yen "collapse"?

Let's answer the first question first: why did the yen collapse?

This answer may not be complicated - that is, market participants suddenly realized one thing after the Bank of Japan decision this month: ending negative interest rates will not actually save the yen, but the Bank of Japan's interest rate hike, which was originally hanging over the "head" of USD/JPY, can no longer make yen bears feel jealous after the real boots land!

In fact, a relatively accepted view in the market is that although the Bank of Japan (BOJ) last week offered a series of tightening combinations of "ending negative interest rates, removing yield curve control (YCC), and stopping ETF purchases", the BOJ's future tightening action will still be gradual and slow. The country's long-term prospects for monetary easing will not be reversed completely, especially relative to other central banks in other economies where interest rates are still at their peaks in decades.

This can also be confirmed in the speech of today's so-called "most hawkish" official within the Bank of Japan.

Bank of Japan (BOJ) member Naoki Tamura said on Wednesday that the way monetary policy is managed is critical to slowly and steadily normalizing policy and ending super-massive monetary easing. But he also noted that the accommodative environment in financial markets is likely to continue, and there is less risk of rapid rate hikes. Normalization means restoring the function of interest rates affecting the economy and achieving the 2% inflation target. After his speech, the yen clearly extended its decline.

In a list of the industry's hawk doves, Naoki Tamura is the most hawkish of the BOJ's nine board members. But there is no doubt that his latest speech is not as "hawkish" as one might think.

In Tamura's latest speech, he did not give a clear hint about the next normalization measures. And according to most BOJ observers, the next rate cut will not be until at least October this year.

This suggests that the yield gap between US and JGBs is likely to remain above 400 basis points for the long term for most of the year, and that the returns from the "carry trade" may still be considerable. Currently, the yield on two-year US Treasury bonds is around 4.593%, while the yield on Japanese two-year government bonds is around 0.191%, which makes dollar-denominated assets more attractive, where investors borrow cheap yen and exchange it for dollars to invest in higher-yielding assets.

Is the sharp fall of the yen just the most typical "microcosm" of the global foreign exchange market pattern?

As things stand, if the yen weakens further, it is likely that the intervention of the Japanese authorities will be triggered.

Japanese officials have now warned about speculation in the currency market almost every day about the yen's recent volatility. Japanese Finance Minister Shunichi Suzuki has recently said that he will closely monitor foreign exchange fluctuations with a high sense of urgency and take bold actions on exchange rate issues if necessary.

"The market is very sensitive to the 152 area," said Rodrigo Catril, a strategist at National Australia Bank, "and if we break above that level, then recent history suggests that intervention is much more likely." ”

In addition, many market participants believe that the area where the Bank of Japan is more likely to strike is the 155 mark. Bank of America believes that if the USD/JPY pair reaches the 152-155 range, the risk of intervention will rise, while a Bloomberg survey of economists believes that the exchange rate level that prompted the Japanese Ministry of Finance to intervene is expected to be 155.

Fundamentally, however, any intervention may end up being a palliative measure. In September and October 2022, the Bank of Japan directly intervened in the yen exchange rate twice. But that doesn't change one thing: the yen was once again the worst currency in the G10 last year, and it still remains so so this year.

At the moment, if people look at the world, they may need to worry more about whether the yen, which has collapsed all the way this year, will it just be the most typical microcosm of the strength and weakness of the global foreign exchange market.

Looking at the trend of the year, the dollar index has risen by nearly 3% in the first two months of the year, which is not a large increase on a monthly basis - people have clearly seen more ferocious moments in the dollar's rally last year and the year before. However, if we look at the rise and fall of the major non-US currencies in detail and look at the overall performance of the dollar index, it is not difficult to find that the strength of the dollar so far this year is actually quite "dominant".

The chart below covers the rankings of the world's 35 major currencies against the US dollar during the year. What many may not have expected is that only two non-US currencies – the Kenyan shilling and the Mexican peso – have risen against the US dollar this year. All other non-US currencies, with the exception of the Saudi riyal, which is pegged to the US dollar, fell.

From this perspective, although many domestic investors have recently been worried about the depreciation of the RMB, in fact, the RMB is still in a relatively strong position among the overall non-US currencies this year - it can still rank among the top 10 gainers and losers.

On the contrary, some other Asian currencies seem to be following in the footsteps of the yen at the moment. For example, the won and the rupiah have now fallen to their lowest levels since November. In terms of correlation coefficients, the 60-day correlation index between the won and the yen has reached 0.35, the highest level since May 2023. A value of 1 indicates that the two currencies are moving in perfect synchrony.

Why is there a strong dollar in a year when the Fed cuts interest rates?

So, in a recognized year of Fed rate cuts, why did a strong dollar emerge?

Since the beginning of this year, some dollar-denominated assets represented by gold and bitcoin can be said to be exporting against the headwinds of a strong dollar. However, it is clear that within non-US currencies, it is difficult to resist the "strong wind" of the US dollar at the moment. The reason behind all this is actually very similar to the current weakness of the yen - the interest rate differential factor is still moving in favor of the dollar.

In fact, after the SNB unexpectedly cut interest rates last week – becoming the first central bank in the G10 to pivot to easing – some astute investors in the FX market have already "woken up from a dream" – and they are beginning to realize that the Fed may be one of the "highest and longest" central banks in the world to maintain the peak of interest rates.

Let's start with the G10 central banks, and among the ten central banks, only the Reserve Bank of New Zealand (5.5%) has the same or higher interest rate than the Fed (5.25%-5.5%), and the others are lower than the Fed. Many central banks are also expected to cut interest rates more than the Fed this year, and the most representative shift is the Bank of England - the market has been thinking that the Bank of England will cut interest rates later than the Fed at the beginning of this year (which is why the pound has led the G10 currency for a long time), but with hawkish officials of the Bank of England last week abandoning the insistence on further interest rate hikes and turning dovish, the current market bets on the Bank of England to cut interest rates in June have begun to be higher than the Fed.

How does the Fed, which is among the most hawkish central banks in the G10, compare with emerging markets?

Indeed, many of the emerging market central banks still have benchmark interest rates higher than the Fed, which does not seem to be good for the dollar in terms of interest rate differentials. But don't forget – the vast majority of the central banks that have entered the rate cutting cycle are emerging market central banks, and many of them have already cut interest rates quite a bit, and their policy changes are much faster than the Fed's.

This poses a serious problem: the Fed's interest rates are higher than those of other advanced central banks, and the rate cut cycle starts more slowly than many emerging central banks, making the dollar invincible against other G10 and emerging market currencies in most cases.

All of this has led to a situation in which the dollar is now almost a rival in the foreign exchange market in the first quarter of the Fed's interest rate cut year.

What's more, don't look at the Fed's median dot plot released last week, which is expected to still show three rate cuts this year, but in fact, the specific official voting point ratio is only 10:9 - whether it will be three or two rate cuts is still between the two......

If the US inflation data is still sticky, and the Fed is expected to cut interest rates this year from six at the beginning of the year to three today, or even become less in the future, then you, as an investor, might as well guess - will the dollar rise further next?

(Finance Associated Press Xiaoxiang)