Dear Investors,
The US dollar displayed a strong bull market from mid-2021 to around the end of 2022, driven by a number of factors.
Growth differentials favored the US, particularly as longer lockdowns around COVID in Asia and, from early 2022, effects from the Russia-Ukraine war disadvantaged growth in other regions.
Interest-rate differentials also worked to benefit the dollar, especially as 2022 was characterized by continued hawkish reassessment around the path of the fed funds rate.
Some perceived safe – haven flows due to the Russia Ukraine war also benefited the greenback.
While these factors explain support for the dollar, Franklin Templeton believes the currency overshot and reached extreme valuation levels – even recording multi-decade highs against some currencies – by end-2022.
While a number of global currencies might be expected to improve against the dollar from this point,
Franklin Templeton thinks Asian currencies in particular are poised to benefit from a weaker dollar trend.
Asia in general displays solid economic fundamentals, including healthy fiscal balances, low external debt ratios, strong current account positions, low inflation rates and high relative growth.
Both Japan and China – the region’s two largest economies—are expected to grow robustly as they finally emerge from protracted lockdowns.
This will help regional neighbors as well.
While they anticipate a number of currencies across the region to do well,
they highlight our expectation that the Japanese yen is likely to find further support, having depreciated to multi-decade lows during 2022.
Franklin Templeton anticipates the Bank of Japan may need to rethink its decade-long loose monetary policy,
as the economy picks up with rising inflation, and 2023 is also set to be a rare year when growth in Japan likely exceeds that of the US.
Deep yield-curve inversion
For Charles Schwab the Treasury yield spread is another component of the Leading Economic Index.
As shown above, the spread between 10-year and three-month yields is in deep negative territory.
The severity of the inversion sits behind the spike in the New York Federal Reserve’s recession probability model.
At less than 50%, without historical context, that might not appear alarming;
but as shown below, it has never jumped this high other than during recessions that were already underway.
Asian currencies – The bullishness of the Japanese Yen
Franklin Templeton expects the Japanese economy to grow faster than the US in 2023 – a rare occurrence.
According to the IMF’s October 2022 WEO, Japan is expected to grow notably faster than the US, at 1.6% versus 1.0%.
If this transpires, it would be the first time since 2010 that Japan outperformed the US on growth,
and we note that the Japanese yen (JPY) also appreciated when that previously occurred.
The Japanese economy currently has two main cyclical advantages over the US economy.
First, the reopening boost post-COVID is just beginning, and this should help shift growth differentials in favor of the JPY.
Second, unlike the Fed, the Bank of Japan (BOJ) stayed accommodative throughout most of 2022,
though it adjusted the band around its government bond yield target wider in December.
For Franklin Templeton the BOJ will further normalize policy during 2023.
Japan’s monetary policy
Japan’s monetary policy has been markedly different from that of the rest of the world for some years now.
Yield curve control, implemented in 2016, is one example.
The original idea of yield curve control was to steepen the yield curve enough for banks to have positive margins on their business.
As the table below demonstrates, a side effect of having negative interest rates was evident in the long-term Japanese government bond (JGB) market.
At the end of July 2016, 10-year JGB yields had fallen sharply to almost negative 0.2%, which put pressure on financial markets, especially on bank net interest margins.
On the macro side, inflation has been largely short of the BOJ’s 2% inflation target throughout these policy changes.
Japanese consumers
Another potential impact from the change in the inflation environment is a possible move away from the cash hoarding behavior Japanese consumers have shown until now.
As a result of Japan’s past environment of extremely low inflation or deflation, Japanese households currently hold massive amounts of non-interest-bearing cash and deposit assets.
More than half of Japanese households’ financial assets are held in terms of cash and deposits,
compared to below 15% for the US (BOJ data as of end March 2022, see below).
If inflation persists above 2%, domestic investors may prefer to reallocate assets away from cash holdings toward financial assets.
Other Asian currencies are also likely to do well
Now that China has relaxed its COVID restrictions, we expect its growth to improve in 2023.
The Asian region as a whole is therefore likely to benefit from its closer linkages to the Chinese economy, which is expected to rebound at about the time when the US economy may decelerate further.
Asian countries have either current account surpluses or positive basic balance of payments flows.
Many have significantly larger reserves than their short-term external debt.
Public balance sheets are healthy in general, and many countries are increasing their efforts to consolidate debt (such as seen in South Korea and Indonesia).
The outlook for Asian currencies seems particularly positive, in terms of potentially benefiting from a USD unwind.
While simultaneously emerging from COVID shutdowns toward internally propelled growth and renewed tourism boosts.
Geopolitical tensions between the US and China, country-specific factors, and the path of US interest rates, among other factors, reman risks to this outlook.