Investors were caught off guard last week when the Taiwanese
dollar surged to a multi-year high. Our strategists Michael Zezas
and James Lord look at what was behind this unexpected rally.
Read more insights from Morgan Stanley.
----- Transcript -----
Michael Zezas: Welcome to Thoughts on the
Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed
Income Research and Public Policy Strategy.
James Lord: And I'm James Lord Morgan
Stanley's, Global Head of FX and EM Strategy.
Michael Zezas: Today, we'll focus on some
extreme moves in the currency markets and give you a sense of
what's driving them, and why investors should pay close
attention.
It's Thursday, May 8th at 10am in New York.
James Lord: And 3pm in London.
Michael Zezas: So, James, coming into the
year, the consensus was that the U.S. dollar might strengthen
quite a bit because the U.S. was going to institute tariffs
amongst other things. That's actually not what's happened. So,
can you explain why the dollar's been weakening and why you
expect this trend to continue?
James Lord: I think a big factor for the
weakening in the dollar, at least in the initial part of the year
before the April tariff announcements came through, was a concern
that the U.S. economy was going to be slowing down this year. I
mean, this was against some of the consensus expectations at the
beginning of the year.
In our year ahead outlook, we made this call that the dollar
would be weakening because of the potential weakness in the
U.S. economy, driven by slow down in immigration, limited action
on fiscal policy. And whatever tariffs did come through would be
kind of damaging for the U.S. economy.
And this would all sort of lead to a big slowdown and a kind of
end to the U.S. exceptionalism trade that people now talk about
all the time. And I think since April 1st or April 2nd tariff
announcements came, the tariffs were so large that it raised real
concerns about the damage that was potentially going to happen to
the U.S. economy.
The sort of methodology in which the tariff formulas were created
raised a bit of concern about the credibility of the
announcements. And then we had this constant on again, off again,
on again, off again tariffs. That just created a lot of
uncertainty. And in the context of a 15-year bull market of the
dollar where it had sucked enormous amounts of capital inflows
into the U.S. economy. You know, investors just felt that maybe
it was worth taking a few chips off the table and unwinding a
little bit of that dollar risk. And we've seen that play out
quite notably over the last month. So, I think it's been, yeah,
really that those concerns about growth but also this sort of
uncertainty about policy in general in the context of, you know,
a big bull run for the dollar; and fairly heavy valuations and
positioning. Those have been the main issues, I think.
Michael Zezas: Right, so we've got here
this dynamic where there are economic fundamental reasons the
dollar could keep weakening. But also concerns from investors
overseas, whether they're ultimately founded or not, that they
just might have less demand for owning U.S. dollar denominated
assets because of the U.S. trade dynamic. Now it seems to me, and
correct me if I'm wrong, that there was a major market move in
the past week around the Taiwanese dollar, which reflected these
concerns and created an unusually large move in that
currency. Can you explain that dynamic?
James Lord: Yeah, so we've seen really
significant moves in the Taiwan dollar. In fact, on May 2nd, the
currency saw its largest one-day rally since the 1980s, and over
two days gained over 6.5 percent, which for a Taiwan dollar,
which is pretty low volatility currency usually, these are really
big moves. So in our view, the rally in the Taiwan dollar, and it
was remarkably big. We think it's been mostly driven by Taiwanese
exporters selling some of their dollar assets with a little bit
of foreign equity inflow helping as well. And this is linked back
to the sort of trade negotiations as well.
I mean, as you know, like one of the things that the U.S.
administration has been focused on currency valuations.
Historically, many people in the U.S. administration believe
the dollar is very strong. And so there has been this sort of
issue of currency valuations hanging over the trade negotiations
between the U.S. and various Asian countries. And local media in
Taiwan have been talking about the possibility that as part of a
trade negotiation or trade deal, there could be a currency aspect
to that – where the U.S. government would ask the Taiwanese
authorities to try to push Taiwan dollar stronger.
And you know, I think this sort of media reporting created a
little bit of a -- well, not just a little, a significant shift
from Taiwanese exporters where they suddenly rush to sell their
dollar deposits in to get ahead of any possible effort
from the Taiwanese authorities to strengthen their currency. The
central bank is being very clear on this.
We should have to point this out that the currency has not been
part of the trade deal. And yet this hasn't prevented market
participants from acting on the perceived risk of it being part
of the trade talks. So, you know, Taiwanese exporters own a lot
of dollars. Corporates and individuals in Taiwan hold about $275
billion worth of FX deposits and for an $800 billion or so
economy, that's pretty sizable. So we think that is that dynamic,
which has been the biggest factor in pushing Taiwan
dollar stronger.
Michael Zezas: Right, so the Taiwan dollar
is this interesting case study then in how U.S. public policy
choices might be creating the perception of changes in demand for
the dollar changes in policy around how foreign governments are
supposed to value their currency and investors might be getting
ahead of that.
Are there any other parts of the world where you're looking at
foreign exchange globally, where you see things mispriced in a
way relative to some of these expectations that investors need to
talk about?
James Lord: We do think that the dollar has
further to go. I mean, it's on the downside. It's not necessarily
linked to expectations that currency agreements will be part of
any trade agreement. But, we think the Fed will need to cut rates
quite a bit on the back of the slow down in the U.S. economy. Not
so much this year. But Mike Gapen and Seth Carpenter, and the
U.S. economics team are expecting to see the Fed cut to around
2.5 per cent or so next year. And that's absolutely not priced.
And, And so I think as this slowdown – and, this is more of a
sort of traditional currency driver compared to some of these
other policy issues that we've been talking about. But if the Fed
does indeed cut that far, I do think that that's going to put
some meaningful pressure on the dollar. And on a sort of
interest rate differential perspective, and when we look at what
is mispriced and correctly priced, we see the Fed as being
mispriced, but the ECB is being quite well priced at the moment.
So as that weakening downward pressure comes through on the
dollar, it should be reflected on the euro leg. And we see it
heading up to 1.2. But just on the trade issue, Mike, what's your
view on how those trade negotiations are going? Are we going to
get lots of deals being announced soon?
Michael Zezas: Yeah, so the news flow here
suggests that the U.S. is engaged in multiple negotiations across
the globe and are looking to establish agreements relatively
quickly, which would at least give us some information about what
happens next with regard to the tariffs that are scheduled to
increase after that 90 day pause that was announced in earlier in
April. We don't know much beyond that.
I'd say our expectation is that because the U.S. has enough in
common in terms of interests and how it manages its own economy
and how most of its trading partners manage their own economies –
that there are trade agreements, at least in concept. Perhaps
memorandums of understanding that the U.S. can establish with
more traditional allies, call it Japan, Europe, for example, that
can ultimately put another pause on tariff escalation with those
countries.
We think it'll be harder with China where there are more
fundamental disagreements about how the two countries should
interact with each other economically. And while tariffs could
come down from these very, very high levels with China, we still
see them kind of settling out at still meaningful substantial
headline numbers; call it the 50 to 60 per cent range. And while
that might enable more trade than we're seeing right now with
China because of these 145 per cent tariff levels, it'll still be
substantially less than where we started the year where tariff
levels were, you know, sub 20 per cent for the most part with
China.
So, there is a variety of different things happening. I would
expect the general dynamic to be – we are going to see more
agreements with more counterparties. However, those will mostly
result in more pauses and ongoing negotiation, and so the
uncertainty will not be completely eliminated. And so, to that
point, James, I think I hear you saying that there is potentially
a difference between sometimes currencies move based on general
policy uncertainty and anxieties created around that.
James Lord: Yeah, that's right. I think
that's safer ground, I think for us as currency strategists to be
anchoring our view to because it’s something that we deal with
day in, day out for all economies. The impact of this uncertainty
variable. It could be like, I think directionally supports a
weaker dollar, but sort of quantifying it, understanding like how
much of that is in the price; could it get worse, could it get
better? That's something that's a little bit more difficult to
sort of anchor the view to. So, at the moment we feel that it's
pushing in the same direction as the core view. But the core
view, as you say, is based around those growth and monetary
policy drivers.
So, best practice here is let's keep continuing to anchor to the
fundamentals in our investment view, but sort of recognize that
there are substantial bands of uncertainty that are driven by
U.S. policy choices and by investors' perceptions of what those
policy choices could mean.
Michael Zezas: So, James conversations like
this are extremely helpful to our audience. We'll keep tracking
this carefully. And so, I just want to say thank you for taking
the time to talk with us today.
James Lord: I really enjoyed it. Looking
forward to the next one.
Michael Zezas: Great. And thank you for
listening. If you enjoy the podcast, please leave us a review
wherever you listen to the podcast and share Thoughts on the
Market with a friend or colleague today.
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