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Sometimes It's Hard to Know What You Want - Global Exchanges

FICC Podcasts April 12, 2022
FICC Podcasts April 12, 2022

 

In this episode, we discuss recent developments in the valuations of the Japanese yen, Korean won, Canadian dollar, and euro.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

Hi. Welcome to Episode 39 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson. For this week's episode, my co-host Stephen Gallo and I will be talking about recent developments in the FX values of the Japanese yen, Korean won, Canadian dollar and the euro. The title for this week's episode is Sometimes It's Hard to Know What You Want.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London-based FX strategist. Welcome to Global Exchanges presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York-based FX strategist. I'm Stephen's co-host.

Stephen Gallo:

In each weekly podcast like today's we discuss our perspectives on the global economy in the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

We strive to make this show as interactive as possible. So don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Stephen Gallo:

Okay, Greg, let's get this show on the road. It's April 12th, 2022. And yeah, sometimes it is hard to know what you want. And we're going to do our best today to explain why that's relevant to the FX market. But before we do that, let's take a look at the currencies you mentioned, Greg, and line up the spot returns for our listeners. So year to date, the Japanese yen is a big loser in the FX space. It's caused a lot of drama, particularly when we look at the yen versus the rest of G10, an 8% depreciation versus the dollar since the end of last year.

Stephen Gallo:

The Korean won has been an underperformer in Asia, along with the Taiwanese dollar. The Korean won is down 3.8% year to date. And just as a guide, it's quite well-known that this is the case, but I'll point it out anyway. That is a big move in Asian currency terms, especially when you compare that with the currencies of China, Indonesia, Malaysia, and Thailand, which have barely moved against the dollar this year. And then when we go back to Europe, we move over to the euro is nursing a 4.2% loss against the dollar year to date.

Stephen Gallo:

And we should get into the reasons why that decline is basically half the size of the decline in the yen. And then of course we have the Canadian dollar, which has outperformed considerably this year in relation to its G10 peers, but also in RV terms.

Greg Anderson:

If I could just interject in your discussion of percentages, Stephen and talk about levels, to me the move of the year has got to be in the yen dollar above 125 for the first time since 2015. For those of us who live in the Forex market, it's just a huge story.

Stephen Gallo:

It's a massive story for sure, Greg. So let's dig deeper into this issue for the yen and for Japan. And in order to do that, I want to rewind for a moment by going back a few episodes. I think it was we were recording just after the last BOJ rate decision if memory serves me correctly. When the central bank basically just gave investors the green light to short the yen on a clear case of benign neglect as far as the currency's concerned.

Stephen Gallo:

And Greg, at the time I asked you about the BOJ's rationale for letting the yen weaken given the hit that firms and households would take due to exchange rate pass through. Can you run us through the answers you gave at the time, Greg, and why the current level of the yen has caused so much debate within Japan itself?

Greg Anderson:

As I recall, we were sitting at around 119 in dollar yen at that time, Stephen. I said then that I thought Kuroda's green light would push dollar in higher and maybe eventually push it all the way up to 125. But I was thinking on a three-month horizon, not three weeks. The movement over the last several weeks has just been stunningly rapid. So just to rewind what I said about the BOJ's rationale at that time, what I said is that BOJ Governor Kuroda was staring at a total CPI reading for February. That was plus 0.9% year over year. So still 1.1% below target, which is just an entirely different realm than where the vast majority of other central bank heads are located.

Greg Anderson:

They're all looking at CPI inflation that is way above target. And it's not just this year. For the entirety of this century, Japan has only had two brief interludes where inflation got north of 2%. And one of those was artificially caused by a goods and service tax hike. And the other was caused by the combination of the Tohuku earthquake and then a global commodity price spike. So from Kuroda's perspective, inflation isn't and never has been a problem for Japan and he's 77 years old.

Greg Anderson:

For the majority of his career, the key economic doctrines that he has both read and preached are those of export-led growth and a key component of the export-led growth model is a weak currency. So if there has ever been a trade off between a weak currency that benefits exporters and a strong currency that dampens inflation for consumers, Kuroda has always been on the side of a weak yen. But it's pretty clear that he is now getting pushback and that pushback is coming from the finance ministry, from the prime minister. And just kind of reading between the lines, it seems to also be coming from certain corners within his board and the BOJ.

Greg Anderson:

So we've had various voices verbally intervening to try and slow down the pace of yen weakening. And lots of wondering out loud whether this is a bad thing for the economy at this point. I think the concern is particularly strong for Japanese firms. There is moral pressure in Japan to never raise prices, but input costs have gone up so much that margins have shrunk drastically.

Stephen Gallo:

Margins are certainly getting squeezed, Greg, and Japan isn't alone in relation to that dynamic that's for sure. We'll talk more about out that, but with all that in mind, great commentary, by the way. With all that in mind, what do you think the BOJ's next move is going to be when it announces its policy decision on April 28th?

Stephen Gallo:

Also, do you think there's a risk that Kuroda uses the gap between today and the end of April policy decision to kind of steer markets in a different direction or remove some downward pressure from the yen?

Greg Anderson:

Thanks for refocusing me, Stephen. Between now and April 28th, I would look for more verbal intervention. Although we've gotten to the point now that VI from any one other than Kuroda doesn't mean all that much. But if he were to trot it out and state concern about the FX move, then I think that would probably cause the yen to surge 1% higher or something. I don't think the BOJ is in a position to raise its base rate this year, even though I think CPI inflation will quickly move above 2% in year over terms.

Greg Anderson:

Because last year's cellphone service price cut will roll out of the year over year look back window. Also, I don't think the BOJ can join the QT or quantitative tightening club or anything like that, but since everyone else has stopped QE and is now going the other direction with balance sheet policy by taking at least baby steps towards QT, the BOJ really doesn't need the yield curve control mechanism anymore.

Greg Anderson:

Personally, I think they should just scrap it kind of the way the RBA and others scrapped pandemic funding for lendings programs. You can always bring those things back if there's another emergency, but if the BOJ doesn't want to scrap the program, the other alternative, and perhaps it's just more evolutionary is just to widen the yield curve control ban. Make the ceiling on the 10-year yield old something like 40 basis points or 0.40% or even 50 basis points so that there's no real chance that this ceiling triggers. That should help the yen or at least take some of the downside pressure off the yen and allow it to stabilize for a while.

Greg Anderson:

So with that, I'm kind of sick of the hot seat. Let me turn it over to you, Stephen. With the observation that the Korean won has largely followed the yen this year, even though the BOK doesn't have a negative interest rate. And moreover, the BOK has even hiked this year already and is expected to hike further. So why so weak?

Stephen Gallo:

Right, Greg. The first factor I would mention is I think we're witnessing a sea change in the global currency arena as big net importers of energy and other raw materials with significant value-add from manufacturing in their economies experience a major squeeze on exporter margins. So I think there is an underlying competitiveness issue here, which at the very least is restraining appreciation of currencies like the Korean won.

Stephen Gallo:

When you look at the merchandise trade balance of South Korea, you see a clear downward trend taking hold. So that's one factor. And you're 100% correct, Greg, when you point out that the BOK is different from the BOJ in the sense that it has been lifting its benchmark rate and tightening monetary policy since last August, while the Fed only at ended easing and began tightening in March.

Stephen Gallo:

But I would argue two things, firstly, that the underlying fundamentals related to net trade and energy have been stronger than the impact of 25 basis point rate hikes from the BOK basically every other month. And secondly, the uncertainty over the growth and trade outlooks and concerns within the BOK about having a too strong currency, they have stopped the central bank from tightening even more quickly.

Stephen Gallo:

I think another way to diagnose the weakness in the won is to look at how Chinese policymakers have responded to the current environment with their currency policy. And basically it been by letting the RMB strengthen. And so that's an added downward force on the Korean won. And I think it's partly explained by the fact that exports of goods and services in South Korea account for a much larger share of GDP than they do in China at least today. Compared to where it was a decade or two ago, China is a much more internalized economy than it used to be.

Greg Anderson:

So Stephen, if I could bring us back to our title a little bit. My normal rule of thumb learned for many years in the FX market is that the FX market should just give the central bank what it wants, unless what it wants is just completely out of alignment with the reality of underlying flows.

Greg Anderson:

So at any rate, what does the Bank of Korea want here? Does the BOK want the won to weaken like the yen or stabilize like the renminbi. And if your answer is that the BOK wants stability, then why doesn't it just tighten more aggressively?

Stephen Gallo:

Greg, that's a great way of framing the issues. It seems like I'm always giving you compliments on here, but that is the case. You frame the issues well. I think there are a lot of conflicting opinions amongst South Korean policymakers regarding what is more important, tackling inflation and supporting the currency or responding to downside growth risks and neglecting the currency while hoping that a weak won provides a boost to competitiveness?

Stephen Gallo:

I think that policymakers will probably end up with what they have already, which is basically something in between the performance of the yen and the RMB, but maybe I would go as far as saying that result is probably not going to happen by design. In terms of the BOK tightening more aggressively as you mentioned. Well, look, I think it's likely that South Korea's base rate peaks above where it did during the last cycle.

Stephen Gallo:

But I also think the BOK is constrained in how fast it can tighten by variables like equity market valuations and high household indebtedness, especially if exporters are going to be shedding jobs over the coming quarters to try and protect their margins. So when push comes to shove in terms of the overall picture, the BOK wants stability like all central banks, but there are risks of instability occurring if the central bank is either too slow or too quick to tighten policy.

Greg Anderson:

This issue of high household indebtedness restraining the pace at which the central bank can tighten, it sounds very familiar. When I talk to market been in Canada, I hear that discussion point a lot and I think it has validity in Canada's case. With the much higher share of mortgage and other household debt that is floating in comparison to the US, I don't think the BOC could match the Fed if the Fed were to start hiking in 75s or 100s. But that's just a little digression because I don't think Fed will move any faster than hiking 50 basis points a meeting for at least the next couple of meetings.

Greg Anderson:

So on that point, I think I'm an agreement with our econ team, and like our econ team, I think the BOC will tighten by 50 basis points tomorrow and at least at the next meeting after that. I think the loonie will likely have a bit of a confirmation rally tomorrow as that happens. And particularly I would note on crosses like EUROCAT, but I don't think the loonie is going to run away and hide. Getting back to the issue of what the Bank of Canada might want. The situation is unlike the case of the Asian export-oriented economies we've been talking about in that the exchange rate really hasn't moved this year. So there doesn't need to be a deep think about what exchange rate steering is best for the country.

Greg Anderson:

The Bank of Canada can just take what the market delivers in the FX realm and move on with tackling other issues. But that brings us to Europe. And yes, I know that the dynamics of the ECB are so much more complex than those of the BOC on this issue and many others. But Stephen, with the euro down 4% year to date as you mentioned, please give it your best shot. What does the ECB want the euro to do?

Stephen Gallo:

Okay, Greg, so which country and which member of the Governing Council of the ECCP are you referring to when you ask, "What does the ECB want the euro to do?" The short answer is there is no clear answer, Greg, whereas most central banks can construct a type of roadmap for normalizing policy albeit in this environment with great difficulty. The ECB has a labyrinth to find its way out of.

Stephen Gallo:

I mean, I'm fairly certain that high inflation and the rising cost of living is a problem in virtually every European country now, including those inside the euro area. For example, the Northern bloc of countries, including Germany and the Netherlands have historically tended to favor strong currencies and current account surpluses. But they might also be looking at the current global environment and worrying about becoming less competitive on exports, especially vis-a-vis China.

Stephen Gallo:

At the same time, inflation is also becoming a bigger problem in Southern Europe, the periphery in France. These countries are historically more accustomed to bigger deficits, weaker currencies and high inflation. But policy experts in Southern Europe also know that if the ECB attempts to aggressively tackle inflation, government borrowing costs could soar and that would be a problem for the governments of the countries that I've just mentioned.

Stephen Gallo:

So again, I think like other central banks, the ECB wants stability in the overall picture, but it doesn't have a clear answer for how to achieve it. And that's the big problem here I think when we look across the globe at various different central banks. In terms of the FX market related to the euro, two things stand out, which I think are noteworthy. The first is that net euro dollar short positions are in the process of being trimmed by leverage funds. And I think that's a reasonable non-position to take at the current juncture.

Stephen Gallo:

With all the uncertainty, investors are too scared to be heavily exposed in euro dollar either way right now. However, what's also interesting is that the euro has weakened since the end of Q1 versus the dollar despite those net short positions being trimmed. And that points to an underlying flow dynamic that is fundamentally euro negative. Bottom line, Greg, I think look for the ECB to counter that negative dynamic to a degree, but probably not in the same manner as other central banks have done like the Fed.

Greg Anderson:

This has been an interesting discussion, Stephen, or at least I think so, but I don't know that we've given our listeners anything that's actionable. So as we wind down, let me just conclude with my favorite FX trade at the moment. With the way that oil has seemingly stabilized around or below 100 and with food prices still sky high, I think that the New Zealand dollar way too cheap on a 68 handle. So I like long kiwi at this juncture looking for around 3% appreciation in the New Zealand dollar over the next one to three months call it. What's your favorite standout FX trade at the moment, Stephen?

Stephen Gallo:

Perfect way to end the podcast, Greg. Okay, so my idea is short cable of 130. The rationale I would give here is I think there are a number of holdout longs still lurking out there in cable. There also might be a number of longs, weak longs in the pound versus the euro. And I see a risk that the BOE can't match the Fed or what is priced into the curve in terms of the speed of rate hikes over the next few policy announcements as the growth outlook for the UK deteriorates.

Stephen Gallo:

Secondly, you've got the trade fundamental for sterling, which looks to me like it's getting worse by the month. And thirdly and finally, political risk. Maybe not as high as the extent of risk in mainland Europe, but the current UK government is definitely under pressure for various reasons. And local elections are coming up in early May. And I would expect those results to be tantamount to a referendum on the government's performance. So in light of the global backdrop, in light of geopolitical risk, in light of the number of downside economic growth risks facing Europe right now, I cannot understand why cable's above 130.

Greg Anderson:

So short sterling, long kiwi. Maybe it makes sense to cross it, because that cross does seem to be sitting near breakout level. And I think that's where we should conclude. Thanks listeners. Please join us again next week.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts bmocm.com/globalexchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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