Yuan to surge as yen carry trade goes awry
Yen’s recent rise pushing up the yuan in ways China’s economic mandarins and monetary regulators may not appreciate
TOKYO – Chinese regulators are worried about the impact of a stronger yuan on exporters. Those fears might be validated soon as the so-called “yen carry trade” goes awry across global currency markets.
Ever since the Bank of Japan’s July 31 interest rate hike, the yen’s resulting surge has upended foreign exchange markets.
Twenty-five years of holding rates at zero turned Japan into the globe’s top creditor nation, where for decades investment funds borrowed cheaply in yen to bet on higher-yielding assets worldwide. It became one of the globe’s most crowded trades, one uniquely prone to correction where sudden moves in the yen slammed markets virtually everywhere.
The yen’s 6% rally over the last 22 days has put the yuan under considerable upward pressure. Just as the yen’s weakness earlier this year pulled the yuan down, its rally is pushing the yuan higher in ways Chinese President Xi Jinping might not appreciate.
So far this year, the People’s Bank of China has tried to keep the yuan from sliding too far. A weaker yuan would make it harder for Chinese property developers to honor payments on dollar and other foreign currency-denominated offshore bonds, raising China Evergrande Group-like default risks.
A weaker yuan that makes Chinese exports even more competitive might also irk Washington at the height of a raucous US election campaign in which both Republicans and Democrats have portrayed China as public enemy number one. A falling yuan might also set back Beijing’s efforts to increase trust in the yuan as a store of value and challenge the dollar.
Yet the degree to which the yuan now faces upward pressure may be irking Xi’s inner circle. And that anxiety might be about to intensify if economist Guan Tao, who previously worked for China’s foreign-exchange regulator, the State Administration of Foreign Exchange (SAFE), has it right.
“If people see a signal that the yuan could strengthen by 3% to 4%, they won’t be interested in holding the dollar and profiting from the yield gap,” Guan told Bloomberg. “The carry trade positions will be closed, and it could happen fast.”
Guan, who’s now chief economist at Bank of China International, thinks Beijing will tolerate yuan appreciation to some extent. Doing so might, at the margin, tame the worst capital outflows from China since at least 2016. The trend appears to have spooked Xi’s team so much so that regulators have moved to release less high-frequency data.
“Beijing stopped the release because the data hasn’t been looking good, and it’s volatile,” notes Xin Yao Ng, Asia-region director of investments at abrdn, formerly Standard Life Aberdeen Plc, who stresses that “they probably don’t want the data to amplify capital outflows” but “it doesn’t solve the root of the problem.”
Might that cause control problems for current SAFE officials? Only time will tell, but a marked rise in the yuan could be a major headwind for Asia’s biggest economy at the worst possible moment.
Exports have long been one of the best things China’s economy has going for it. In July, overseas shipments grew 7% year on year. Still, exports are running a bit below forecasts. Continued yuan strength could make this year’s 5% gross domestic product target (GDP) harder to achieve.
One big unknown for China is the direction of US Federal Reserve policy. In 2022 and 2023, Chairman Jerome Powell carried out the Fed’s most aggressive monetary tightening cycle in roughly 20 years, causing Silicon Valley Bank and other mid-size lenders to crash.
Now, the Fed is leaning toward a rate cut as the US employment market shows signs of strain. Traders are paying close attention to Powell’s speech this week in Jackson Hole, Wyoming, at the Fed’s annual conclave for clues as to when and by how much.
“We think Powell’s take will be reassuring and consistent with a soft baseline of a string of 25s, but he will convey the Fed is open to 50s and the bar for this is not very high,” wrote analysts at Evercore ISI.
The investment bank’s economists think Powell will express confidence that inflation pressures are receding, heading back to the Fed’s 2% target. A move could come as soon as next month.
“We don’t expect a hard steer as to whether the first move will be a 25 basis-point or 50 basis-point cut,” Evercore ISI argued. The bank thinks Powell will call any rate move contingent upon upcoming data.
Ed Yardeni, president of Yardeni Research, thinks Powell will cut rates just once and call it quits. He thinks that’s particularly likely if the August jobs report, due out September 6, comes in weak.
Count Yardeni among economists who think the US is stronger than upcoming data might suggest.
“The markets are very dovish,” Yardeni told CNBC. “Expectations are 25 to 50 basis points in the September meeting, I think there’s still expectations that maybe we’ll even have 100 basis points between now and year end.” But on the contrary, Yardeni predicted, “it’s going to be 25 basis points at the September meeting and I think it’s going to be one and done. The economy is just doing too well.”
Another big question mark is the BOJ’s outlook. Additional Japanese rate hikes could send the yen sharply higher, causing the carry trade to explode spectacularly.
Carlos Casanova, economist at Union Bancaire Privée, thinks upcoming data will “reinforce the Bank of Japan’s hawkish policy stance, despite persistent challenges. Therefore, we expect that the BOJ will implement one more 10-25 basis point hike in the fourth quarter. The BOJ’s pivot has led to market volatility and expectations of yen strengthening, which could erode imported inflation benefits and dampen tourism spending.”
Economists at Fitch’s BMI Research “expect that the BOJ will take a more cautious approach and only hike by 25 basis points this year to 0.50%, down from our previous view for 50 basis points” of additional tightening.
But three unknowns hang heavy over markets. One, the BOJ interest rate hike cycle for which many traders are bracing may be far more mild than even dovish economists expect.
Two, a widening yield curve band could prompt the BOJ to leave rates on hold for the rest of 2024. Three, Governor Kazuo Ueda is more trapped in the world’s boldest experiment with ultra-loose monetary policy than markets seem to realize.
From March 2013 to April 23, Ueda’s predecessor Haruhiko Kuroda cornered Japan’s government bond market and became by far the biggest holder of stocks via exchange-traded funds. The BOJ gorged on assets across the economy in a bid to end 20-plus years of deflation and malaise.
Kuroda was tapped by the late Shinzo Abe, prime minister from 2012 to 2020, and didn’t disappoint: his “shock and awe” campaign was so aggressive that it drove the yen down 30% in short order. By 2018, the BOJ’s balance sheet topped the size of Japan’s entire $5 trillion economy, a first for a Group of Seven nation.
But the odds of Ueda now taking big risks to normalize rates may be a reach. Prime Minister Fumio Kishida, who took office in October 2021, has been as cautious a Liberal Democratic leader as Japan has had in decades.
Yet rising inflation, Tokyo’s deteriorating security situation, a series of scandals among his cabinet members and fallout from Abe’s assassination in July 2022 have conspired to drop Kishida’s approval rating into the 20s.
Last week, Kishida announced he won’t run for another term at the LDP’s party election in September. One reason is the complete failure to implement any part of his “new capitalism” plan to raise living standards and rekindle Japan’s innovative animal spirits.
Now that Japan is experiencing the inflation that the BOJ was tasked with generating, it’s largely the “bad” kind—imported via elevated commodity prices and an undervalued exchange rate.
Yet many economists worry Japan isn’t as ready for tighter monetary policy as many believe as higher rates could thrust the economy back toward recession. Though wages are showing signs of life, paychecks have flatlined for 25 years, a pre-existing condition made worse by the last two-plus years of Covid-19 trauma. Nothing Kishida did these last 34-plus months is likely to increase Japanese prosperity.
One flash of good news: In June, inflation-adjusted wages rose for the first time in 27 months, up 1.1% from a year earlier.
“The results are simply positive overall, with signs for a pick-up in private consumption backed by real wage growth,” says economist Kazutaka Maeda at Meiji Yasuda Research Institute. “It supports the BOJ’s view and bodes well with further rate hikes, although the central bank would remain cautious as the last rate increase had caused a sharp spike in the yen.”
Of course, the June wage jump is still less than half the rate of inflation. Still, Ueda could surprise markets with more assertive-than-expected rate hikes. The resulting shockwaves could complicate China’s economic outlook in particular. The same goes for what happens in the US in the months ahead.
“Looking forward, we believe that it may not be necessary for China’s central bank to guide the continued appreciation of the yuan,” economists at Guotai Junan Securities wrote in a note. “In the short term, the yuan exchange rate may depend more on the performance of US economic data.”
The yuan’s trajectory also will depend on how much fiscal stimulus Xi’s government pumps into the economy. “Policymakers are likely to rush to provide more stimulus, such as accelerating special bond issuance and the purchase of housing inventory from developers,” said Larry Hu, chief China economist of Macquarie Capital. “It seems that policymakers can’t miss the growth target, but they don’t want to over-deliver either.”
Economists at Capital Economics argue that “with private credit demand remaining weak, the PBOC’s recent rate cuts are insufficient to drive a significant recovery. “We anticipate only a further 20 basis point cut to the loan prime rate this year, which won’t be enough to sustain a resurgence in credit demand.”
Goldman Sachs analysts added that, as the PBOC highlights “the importance of counter-cyclical adjustment to support domestic demand, we maintain our forecast for a 25 basis-point [reserve requirement ratio] cut in the third quarter to facilitate increased government bond issuance and a 10 basis-point policy rate cut in the fourth quarter to lower funding costs for the real economy.”
But much of how Pan Gongsheng responds to global events for the rest of 2024 may depend on decisions in Tokyo, where his counterpart at the BOJ holds the fate of the yen-carry trade in his hands.
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