Tao Dong: The U.S. bond dollar has changed abruptly, and the Asian financial crisis has reappeared?

Tao Dong is a director of the China Chief Economist Forum

Powell's remarks and Iranian missiles blew up risky assets, and global stock markets fell for six consecutive days, leading the magic seven of U.S. stocks to plunge nearly 8% last week. Funds decided to take profits in the face of several market risks, with EPFR data showing $21.1 billion exiting the equity market in the past two weeks. Last Tuesday, Fed President Jerome Powell said that the "bumps" on the road to fighting inflation proved that he was right to take a wait-and-see attitude on the policy of cutting interest rates, and several other senior Fed officials were more straightforward in acknowledging that greater confidence in the fall in prices was needed before considering cutting interest rates. The two-year U.S. Treasury rate has rushed to the edge of 5%, and Treasuries continue to experience selling pressure.

Stimulated by inflation data and the Fed's attitude, the U.S. dollar interest rate has skyrocketed, the U.S. dollar index has reached a high above 106, and the yen has returned to 1990 levels. At the same time, Iran's missile and drone attacks on Israel have returned the favor, and while the damage caused by their actions has been limited, geopolitical risks have risen sharply, funds have sought safe havens, gold prices have hit record highs, and other industrial metals have also soared under the stimulus of their financial attributes. Interestingly, both Brent and USWC crude oil prices retreated.

The market's reassessment and repricing of the outlook for the U.S. policy rate led to a broad rebound in the U.S. dollar exchange rate and a decline in the exchange rates of Asian countries, reminiscent of the 1997 Asian financial crisis.

Historically, every time the U.S. enters a cycle of high interest rates and strong exchange rates, emerging markets will face tremendous pressure. When U.S. interest rates are high, capital flows back into the U.S. dollar area from emerging markets, pushing up the U.S. dollar exchange rate, pushing up U.S. dollar asset prices, and attracting more capital out of emerging markets. Emerging market countries have used their foreign exchange reserves to maintain exchange rate stability, but as reserves have rapidly depleted, fundamentals have deteriorated, and more foreign money (as well as domestic funds) has fled. Many emerging countries have accumulated a large amount of US dollar debt, and once foreign capital withdraws, US dollar liquidity will soon dry up, and debt crises will easily erupt.

The last round of sustained US dollar strength occurred from 1995 to 2000, which triggered the debt crisis in Mexico, Asia, Russia, and Argentina/Brazil. In every sense, high interest rates in the United States and a rising dollar are a threat to emerging market economies. From 2020 to 2022, there was a wave of appreciation in the US dollar, which was basically the inflow of funds into the United States during the epidemic to avoid safety, but the time was short, and the dollar quickly turned around and fell, and only a few emerging countries such as Sri Lanka and Argentina were affected.

Now that the US dollar exchange rate has turned around and risen sharply, putting a number of Asian currencies, including the yen and the South Korean won, under the pressure of depreciation, will the Asian financial crisis return? The author believes that there is little chance because the economic fundamentals in Asia today are very different from those of 27 years ago. At that time, Asian countries were overleveraged and owed huge amounts of US dollar debt, but now most Asian countries have relatively low levels of external debt compared to their own economies, and the ratio of short-term debt to foreign exchange reserves is mostly appropriate. Moreover, the proportion of industrial investment in the inflow of foreign capital has increased significantly, and these funds are generally not affected by interest rates.

More importantly, after the 1997 crisis, most countries revised their exchange rate formation mechanisms, and their currencies mostly used floating exchange rates. This makes central banks do not need to desperately intervene in the foreign exchange market to protect the exchange rate, and there is more room for policy maneuver and less chance of being sniped by speculators. The author does not rule out debt crises in other emerging market regions, but I believe that there is little chance of a recurrence of a systemic financial crisis like the 97 financial crisis in Asia. Particular attention should be paid to individual countries and regions with high levels of debt or lack of exchange rate flexibility.

Of course, if the U.S. dollar exchange rate continues to remain high, funds will inevitably flow further to U.S. dollar assets, which will have an impact on the direction of global asset allocation and the growth of asset prices. It is obviously the inflation problem in the United States, the interest rate problem in the United States, but it is the leeks of the whole world that are cut.

Recently, there have been two major events in Japan that have been seen for a long time. The first is that Japan has finally emerged from the era of deflation after 30 years. Prime Minister Kishida called it "a historic moment to witness once in a lifetime, stepping out of the era of deflation". The second is that the yen fell below 154 against the dollar, and the last time we saw this number was in 1990, which is another once-in-a-generation time. It stands to reason that since Japan is out of deflation and the Bank of Japan has started to raise interest rates, the yen should appreciate.

First of all, the main reason for this round of yen depreciation comes from the United States, where inflation is unexpectedly high, and the market has revised its expectations for U.S. interest rate cuts, which has triggered a correction in the U.S. Treasury market, thus leading to a chain reaction in asset pricing. The yen is passively depreciated. Second, the market sees the Bank of Japan's interest rate hike in April as a policy normalization, that is, a departure from yield curve management and an exit from negative interest rate policy. This does not necessarily mean that there is a lot of room for interest rates in Japan to rise in the future, and the interest rate gap between the United States and Japan will remain maintained.

Former Bank of Japan Governor Haruhiko Kuroda once said that the deflationary mentality of the Japanese is deeply entrenched, and I am afraid that it cannot be reversed immediately by a few CPI data. In fact, when talking about Japan's economic recovery and the rise in the stock market, foreigners are more excited than Japanese. Real purchasing power after inflation is still relatively weak, and the people are still quite cautious about the future prospects, and they are still very worried about the country's demographics and debt burden.

In the author's view, the Japanese economy has emerged from the vicious circle brought about by the deflationary environment, and various economic indicators and macroeconomic policies are moving towards normalization. However, the structural problems have not disappeared, the shadow of insufficient domestic demand and private investment lingers, and traditional fist export products are also facing the problem of declining competitiveness, so the potential growth rate of the Japanese economy may not make a major breakthrough in the short term.

However, the depreciation of the yen will have a significant positive effect on the earnings of many listed companies. Although foreign investors have stepped up their efforts to enter the Japanese stock market, the average allocation of long-term funds to Japan is still at a neutral low level. The Japanese stock market has not yet seen the grand occasion of seven AI companies in the United States and eleven of the largest companies in the European stock market. As for the exchange rate, the yen's recovery will not happen until the dust settles on the US interest rate revaluation trade, and the opportunity for a sharp appreciation will need to wait for the savings of Japanese companies and households stranded overseas to start returning.

This week, we will focus on three points: 1) U.S. GDP growth in the first quarter is expected to reach an annualized rate of 2.7% quarter-on-quarter, a sharp decline from the previous period, but the growth rate is still too fast. 2) U.S. PCE inflation in March is expected to be 2.6% year-on-year, slightly higher than the previous period. 3) At the regular meeting of the Bank of Japan, the interest rate policy is expected to remain unchanged, and Ueda is concerned about the hints of interest rate hikes and monetary contraction. In addition, special attention needs to be paid to how the Iran-Israel conflict develops.