Currencies & Rates

A Stronger Dollar

The DXY dollar index which tracks the US dollar against a basket of other leading currencies is up by four percent this year. That suggests that the dollar has been strengthening – but not dramatically so. The index is still well below the record high it struck in 2024. However, most analysts expect the dollar has much further to go given prevailing interest rate expectations.

The Fed will most probably cut rates before the end of this year but not before September – or that is the working assumption in the markets. In contrast, the ECB is expected to cut rates sooner rather than later. And while the Bank of Japan increased rates on 19 March for the first time in 17 years, they remain at zero to 0.1 percent. Thus, Japan is the last country to maintain near-zero interest rates; and the differential between Japanese and US rates is as wide as ever.

In late April, Goldman Sachs said it expected the dollar to be “stronger for longer”. The focus now is on the dollar-yen exchange rate (around 155 yen to the dollar this morning – that is a 34-year low). The yen has been falling against the dollar steadily since the first quarter of 2022. This is problematic for Japan even though the central bank has been hoping for a weaker exchange rate for some time.

Both Japan and South Korea expressed their concerns about US monetary policy to US Treasury Secretary Janet Yellen last month. That is ironic as Ms Yellen – the only person ever to have been Chair of the Federal Reserve and Treasury Secretary – is now only responsible for fiscal policy and has no say over the direction of interest rates. Last week the Bank of Japan spent an estimated Y9 trillion (about $59 billion) in trying to prop up the falling yen. Anecdotally, some Japanese are cancelling foreign holidays because they have become too expensive.

In late April, Indonesia’s central bank surprised the markets by raising interest rates in an attempt to bolster the rupiah, which has been falling of late. Depreciating currencies are not all bad news: they make exports more competitive. But rapidly declining currencies can unleash domestic inflation as the cost of imported staples surge.

Meanwhile, the euro is looking weak. Barclays is amongst others in warning that the value of the common currency could decline further. It’s not just a matter of interest rate expectations but also the fear that a second Trump administration might impose swingeing trade tariffs on European exports to the USA.

The issue is that the US economy is growing faster than those of its main trading partners in the developed world, and that has inflationary consequences.

The Japanese Exception

Japan’s is an ageing and possibly shrinking economy which is only just emerging from decades of deflation. Reportedly, the depreciation of Japan’s currency has prompted Japanese consumers to curtail spending on meals out, overseas travel, transportation and hobbies. It seems that there is a cost of living crisis in Japan as well as here. On the other hand, Japan is experiencing something of an in-bound tourist boom because foreigners no longer find Tokyo and other great Japanese cities quite so eye-wateringly expensive.

Japanese CEOs have been warning of higher raw materials costs and weaker domestic consumption as wage rises fail to keep pace with price rises. There is a paradox at work here. The weakness of the yen arises because of the colossal differential in interest rates between Japan (effectively zero) and the USA (5.25-5.5 percent). But the Bank of Japan (BoJ) fears that if it raises rates further that would squeeze consumption even more. BoJ Governor Kazuo Ueda appeared to play down the risks of a weaker yen last week when he announced that Japanese rates would remain unchanged.

The weaker yen has also had the benefit of stimulating foreign investment in Japan. Taiwan Semiconductor Manufacturing Company (TSMC), the world’s largest producer of computer chips, Microsoft and Oracle have all announced major investments in Japan recently. Moreover, Japanese companies which are reliant on exports abroad such as Nintendo, Toyota and chip-maker Tokyo Electron are booming. That has helped the Nikei-225 stock index to regain and indeed exceed its 1989 record high. It’s running at 38,216 this morning.

Analysts think the BoJ will likely raise rates again in July if real wages pick up and consumption recovers. If the BoJ signals a reduction in bond purchases – that is, if it desists from QE and begins a programme of tighter money – that may support the currency.

If we wish to understand why Japan is such an outlier in terms of interest rate policy we need to look back nearly four decades to the Great Japanese Bubble of the 1980s. Japan had risen from the devastation of defeat in war in 1945 to become an industrial powerhouse in the 1980s with an unrivalled pack of multinational corporations – Sony, Toyota and the rest – and nine of the ten largest banks in the world by total assets. Between 1970 and 1991, Japanese overseas investment grew one hundredfold. Japanese companies purchased trophy American assets such as film studios and skyscrapers in New York and Los Angeles. On 30 March 1987, Japanese insurance magnate Yasuo Goto even bought Van Gogh’s Vase with Fifteen Sunflowers at auction at Christie’s for about $40 million – at the time a record price for a work of art. The Japanese seemed to have more money than anyone else and Japan seemed set to overtake the USA as the world’s pre-eminent economy.

Even though Japanese interest rates at the time were higher than those prevailing in the United States, the lending criteria of Japanese banks were highly permissive. Mortgages on house purchases were often more than 100 percent of the property value. Property prices soared. I remember that when I was in Tokyo in the late 1980s I was told that the (theoretical) market value of the imperial palace and its grounds was greater than all the real estate in California combined.

It was common practice for bank managers to ring up customers and beg them to borrow money. The major banks set sky-high quotas for their branches to boost the volume of loan assets. As a result, Japanese banks’ capital ratios (equity capital as a proportion of total assets) slumped – in some cases to below 3 percent. This was, after all, before the Basel Framework (devised by the Bank of International Settlements) capital adequacy requirements came into force in the early 1990s.

According to German research economist Richard Werner, as reported by Will Dunn in an important recent article in The New Stateman, the impetus for Japanese banks to generate huge quantities of new loan assets came from the very top – from the Bank of Japan itself. Monetary policy only took centre stage in Europe and North America in the aftermath of the 2008-09 financial crisis. But the Bank of Japan had been given unprecedented control over the economy long before then. Japanese banks danced to the tune sung by the BoJ.

Of course, it all ended in tears. Eventually, the bubble burst. As soon as the banks reined back their compulsive lending, asset prices – real estate and equities – began to plunge. In late 1991 the stock market crashed, and Japan’s “lost decade” began. In order to stabilise the banking sector, the BoJ printed money to buy up baskets of non-performing property loans from the commercial banks. As the volume of money in the economy contracted, so interest rates were slashed to near-zero levels, where they have remained until this day.

And it was the BoJ which initiated the first programme by any central bank of quantitative easing (QE) in March 2001. Instead of buying junk loans to save the banks, the BoJ started to buy sound financial assets in the form of government and corporate bonds. The money created by these purchases was intended to stimulate the economy. The Federal Reserve, the ECB and the Bank of England began programmes of QE much later in March 2009 during the fallout from the financial crisis. The combination of near-zero interest rates with ongoing QE was the “unconventional policy” articulated by Federal Reserve Chairman Ben Bernanke at the Jackson Hole conference of central bankers in the autumn of 2010. This was later christened “active monetary policy” by George Osborne in his Mansion House speech of 2013.

The problem is that neither the BoJ nor subsequently its imitators were able to generate much growth by printing huge amounts of new money. QE certainly had the effect of stimulating asset prices – which benefitted the rich most – but actually did little to stimulate output. That is why levels of wealth inequality have risen across the developed world in the last 15 years.

Japan has an additional problem. The slow but steady decline in the country’s population is deflationary. Japan’s population peaked at 128.2 million in 2009 but is now down to 122.7 million. On the basis of the current fertility rate, Japan’s population is set fall to below 100 million by mid-century without widescale immigration. President Biden recently accused Japan of being “xenophobic” because the country does not encourage immigration. For their part, the Japanese look at the chaos on America’s southern border and demur.

Fundamentally, demographics aside, Japan has never recovered from a boom that was artificially engineered by its central bank.

Meanwhile, Back In The USA… And The UK

Then we come back to the question of why inflation is proving more difficult to tame in the USA than in the Eurozone, Japan or the UK. There is one obvious factor. The Biden administration has unleashed a huge fiscal stimulus package subsequent to the Inflation Reduction Act of 2022 with its lavish subsidies for renewable energy and battery electric vehicle production – so long as all the inputs are manufactured within the USA. The Federal government’s fiscal deficit is bigger than ever – it will come in at around nine percent this year.

For all that, the US markets this week evaluate a 65 percent probability of a rate cut by September (up from 46 percent last month) and a 56 percent probability of two rate cuts by December. As a result, US bond yields have fallen back to roughly where they were before April’s shock inflation number of 3.5 percent. Clearly, the credibility of the Fed’s two percent inflation target has been restored. Well done Jerome Powell for excellent central banking PR!

As for the UK, on Thursday (09 May) the Monetary Policy Committee (MPC) of the Bank of England left the UK base rate unchanged at 5.25 percent, where it has been since August last year. Only one MPC member voted for a cut. Governor Andrew Bailey said: “It is likely that we will need to cut bank rate over the coming quarters”, adding that the extent of those cuts would be “possibly more than currently priced into market rates”. He said he was “optimistic” that inflation would continue to fall. The pound eased marginally in response to his words to $1.2573.

The markets are now expecting a cut in the base rate in October, though it could be as early as 01 August. That may be too late and too little to restore the Tories’ popularity with the British electorate who will almost certainly go the polls in the fourth quarter of this year.

Conclusion

When the rate of increase in the money supply (which the Bank of England no longer records) exceeds the rate of growth, inflation will ensue. That is what happened by the end of 2021 when inflation spiked across Europe and North America – and preternaturally in the UK. But, contrary to what some central bankers seem to believe, it is not the amount of money circulating in the economy which drives economic growth; rather it is the efficiency with which capital is allocated. And, as Mrs Thatcher understood, it’s not the job of governments to pick winners and drop losers – that is the task of the market.

Now that the leading central banks have moved from quantitative easing to monetary tightening, the main economic concern is how currencies might weaken given relative interest rate expectations. All eyes are on the Fed.

Afterword: Tories in Trouble

The local elections in England and Wales which took place on Thursday last week (02 May) were, as expected, calamitous for the Tories – but not entirely catastrophic. The Tories lost 474 council seats while Labour gained 186.

The breakdown of votes was something like: Labour 34 percent; Conservatives 26 percent; Liberal Democrats 17 percent; others (including the Greens who won 74 council seats and now have 181 in total) 23 percent. These figures tell a different story to that of the national opinion polls which have consistently put Labour 20 percent or more ahead of the Tories.

It was perfectly reasonable for Mr Sunak to say last weekend that if these figures were replicated at a general election for the House of Commons, the outcome would be a hung parliament. Moreover, the Tories won 19 out of the 33 elections for police commissioner, suggesting that they are still favoured on “law and order”. Ben Houchen was re-elected mayor for Tees Valley and Andy Street was defeated as mayor of the West Midlands by a tiny margin of 0.8 percent. Labour apparently lost votes in areas with sizeable Muslim communities.

This said, as we all know, local elections work differently from general elections. Many more independents (and cranks) win through in council elections; there is widespread tactical voting; local heroes (like Ben (Lord) Houchen) often defy their party’s unpopularity; and relatively few Reform candidates stood for election this time for reasons which are unclear. In contrast, in general elections people vote principally for the party they hope will form the next government and therefore who will become prime minister. On the basis of the Blackpool South by-election result – where there was a swing to Labour of over 25 percent – Tory MPs must be quaking in their boots. No doubt that is why so many of them are already in the jobs market.

Standing back a bit, one has to ask: Why have the Tories who polled 43.6 percent of the vote in the last general election of December 2019 lost so much popularity? The answer is evident. Household consumption in the UK was still 1.9 percent lower at the end of last year than in the final three months of 2019 when adjusted for inflation, according to the OECD. Shadow Chancellor Rachel Reeves is right to say that living standards in the UK have fallen significantly in this parliament. Discretionary spending has been impacted by massive hikes in food and energy prices as well as (on account of rising interest rates) soaring mortgage repayments and monthly rental costs. People feel worse off because they are worse off.

Is that entirely down to the Tories? That will be the subject of another article. They have had to handle the lingering aftermath of the banking crash, then Brexit, then Covid, then Russia-Ukraine and now Israel-Hamas in quick succession. Would Labour have done much better? I’ll leave that with you.

But the point is that people who have always believed that living standards can only rise year on year have been disabused. Whether the citizenry will ever accept that economic progress is non-linear is another question. In the meantime, they will vote according to how well-off they feel.

As Bill Clinton once said: “It’s the economy, stupid”.