While your attention was probably focused on this big takeover of a certain social media site, the swings in the global currency markets were arguably even wilder and probably bigger.
Asian currencies, including the Chinese yuan and Japanese yen, posted their biggest declines in years, while halfway around the world the euro fell to its lowest level in five years. Granted, much of the declines reflect the strength of the greenback, stemming from soaring US bond yields this year. But there are other particular aspects that disturb the currencies.
Allow me to digress into a bit of theory here. Policy makers face a trilemma; they can only control two of the three factors: domestic monetary policy, exchange rates or capital flows. In most advanced economies, the free movement of capital is allowed, leaving the choice between adjusting the value of the currency or domestic policy (in most cases, through interest rates). More often than not, when these last two considerations come into conflict, it is the currency that adjusts, rather than domestic politics.
This is most evident currently in Japan, where the yen plunged past 130 to the dollar last week, a 12% weakening since early March and a 20-year low. This was capped by a fall of almost 1.8% after the
Bank of Japan
affirmed its cap on the yield on 10-year government bonds at 0.25%. Maintaining this red line meant buying more bonds with newly printed yen, depressing the currency.
This marks a significant shift for the yen, which has been seen as a haven in times of volatility, rather than a center of volatility. But Bank of Japan Governor Haruhiko Kuroda on Thursday reiterated the central bank’s yield curve control policy and endorsed a weak yen as positive for the Japanese economy. But as reported here a month ago, the BoJ’s aggressive monetary expansion has failed to stimulate the economy. Indeed, the weakness of the yen exacerbates the weight of the surge in oil prices, invoiced in more expensive dollars.
The yen’s decline has spread across East Asia, particularly China, adding to the pressure of self-inflicted damage from the virtual shutdown of major cities including Beijing and Shanghai. Nevertheless, Chinese President Xi Jinping reportedly ordered officials to produce 5.5% economic growth this year, leading the United States, reports the Wall Street Journal.
Any notion of 5.5% growth in 2022 died as major cities began their descent into the Covid Zero lockdown, writes Leland Miller, CEO of authoritative advice China Beige Book, in an email.
Notwithstanding Xi’s comments, investors should ignore any year-end growth estimates coming out of China, Miller continued. Actual growth will be determined by the extent of Covid lockdowns over the next six weeks. “If you are a Chinese bull, you better pray the lockdown reports from Beijing get overhyped. But I wouldn’t bet on it,” he adds.
In this deteriorated internal context, the Chinese authorities have chosen to allow the exchange rate of the yuan, generally tightly controlled, to fall sharply, by around 3.9% against the dollar since mid-April alone. This is the biggest decline since the 2015 mini-devaluation that shook global markets, Julian Emanuel, chief equity and derivatives strategist at Evercore ISI, said in a client note.
The People’s Bank of China’s mandate is to maintain the “relative stability” of the yuan “in a sea of distress,” Miller adds. These waters are being churned by mounting domestic pressures, hikes in global central bank policy rates and the soaring US dollar. To some extent, the yuan’s decline is a catch-up move towards emerging market currencies that previously slumped against the greenback, according to a research report from Alpine Macro.
That said, the sudden drop in the yuan follows other national monetary and fiscal measures (including even more infrastructure projects) that Beijing has taken, effectively pressing the accelerator pedal while keeping the other foot on the brake with the blockages.
Meanwhile, the euro has slipped around 8% since January to hit a five-year low around $1.05. Much of the fall has come since Russia’s invasion of Ukraine, which began Feb. 24, but the common currency’s decline was already underway earlier. Since the end of last May, it has fallen by more than 14%.
The European Central Bank is expected to follow the Federal Reserve and start raising its key deposit rate by minus 0.5% this summer. That would still leave the key ECB rate more than two percentage points below the 2.00% to 2.25% range where the futures market currently thinks the US central bank will set its fed funds target after its political meeting of July 26 and 27, according to the WEC’s FedWatch site.
The ECB faces a political conundrum. Russia’s war against Ukraine has put pressure on Eurozone economies, mainly through soaring oil and gas prices. This, in turn, was exacerbated by the decline in the common currency, which made dollar-denominated commodities even more expensive. With Eurozone inflation at 7.5% annualized, the ECB is expected to raise its key rate out of negative territory. But in the absence of strong domestic demand, according to Alpine Macro, the economic bloc relies heavily on exports to China and the United States, which could falter if those two economies stumble.
The strong dollar, however, helps the Fed rein in inflation, doing some of the work for planned interest rate hikes. But as first-quarter earnings reports from US multinationals demonstrate, the greenback is weighing on earnings overseas.
Whatever the impacts, volatile currency markets tend to reflect unstable conditions that can be found in bond and stock markets. For that reason alone, they should be on investors’ radar.
Read more from top to bottom of Wall Street:A difficult month hits stocks hard but spares the real economy
Write to Randall W. Forsyth at [email protected]