Japan, supply shocks and EM FX

(upbeat music) - Read Check, where macro meets markets. A podcast from Deutsche Bank Research. - Hello and welcome to Read Check, a podcast from Deutsche Bank Research. I'm Shrews Gopal, FX strategist here at the bank, and I'm joined as always by my co-host and macro strategist, Henry Allen. - Hey Shrews. - Henry, there's a lot going on, even at the time of recording markets, very volatile. What's caught your eye over the past couple of weeks since we last recorded? - Yeah, so it's interesting time to be doing this because the time of recording, we've actually had a pretty big sell-off in the rate space today, primarily on the back of some very strong PMI numbers from around the world. We've just found out the US composite PMI, the flash PMI that is for September, hit a five year high. And earlier in the day, the Eurozone composite PMI was at a three year high as well. So actually, we've seen a lot of resilience in the growth data. And what that's meant is that markets are increasingly worried that central banks are now going to launch. And indeed, they've begun, in many cases, a more aggressive tightening cycle than expected, which actually ties into some of the content. We've written on how markets tend to underestimate the scale of tightening cycles when they begin. And that's kind of the big story of the last two weeks. We had the ECB deliver the second hike of this cycle. And what was quite a hawkish hike in many respects, they said in their statement that they expected inflation to be above target for an extended period. We then had the Bank of Japan who raised rates as well, taking their policy rate up to 1.25%. And that might not sound a lot compared to the US and Europe, but that's actually the highest they've had rates since 1995. So again, normalizing policy after a long year of ultra accommodative monetary policy. And then of course, we had the Fed who only last week delivered their first rate hike since 2023. And their dock lot signaled there was likely at least one more to come this year. So lots happier, it's clear that central banks are now in a globally synchronized hiking cycle once again. So as you say, Henry, there's more to come from these core central banks in developed markets. We now expect two more hikes from the Federal Reserve over the next six months and markets are pricing in risk premium over and above that. We are starting to see that feed into the currency space. And most notably since the start of the month, there has been a bit of weakness in one complex which previously had been very, very strong and resilient to that point. And that is the emerging market effects space. And so with that in mind, we're delighted to be joined by our head of CMEA and Latin FX research. Again, Oliver Harvey, who's here with us in London. Hello, Ollie. Hello, hi, Tres. Hi, Henry, thanks for having me on. We're really excited to have you here. So a couple of weeks ago, you said out of a multitude of reasons why now want to be a little bit more cautious on EMFX after a great run. US real rates going up was one part of it, but there's a plethora of arguments that you've set out as to why the tide may be turning for EMFX. What's top of mind at the moment? Yeah. So I think US real rates is a very important component in the story. It's worth bearing in mind up until now. Emerging markets have been very resilient in the face of what has been a pretty significant sell off in core rates. So as we're speaking now, the US 10 year is above 5%. What could change that and could EM become a little bit more vulnerable? I think there are two schools of thought. Are we seeing this big sell off in rates because the world is worried about inflation? Are we worried about dollar debatement? Is that feeding itself into a weaker dollar? The dollar cycle, when we get a weaker dollar cycle, is usually very supportive of emerging markets. But there is, of course, another alternative. And as you said, it's really been real rates that have led this sell off in US rates rather than inflation. In fact, if you look at the five-year, five-year US real rate, that's reprised by about 100 basis points since the start of the year. And I think that may well be because the market is upgrading its view on potential US growth. And of course, we have this extremely strong data earlier today, but we've also seen this incredible CapEx cycle due to AI in part and this run of positive economic surprises. I think for risk for emerging markets now is number one, the interest rate differential, either nominal or real between EM and the US has compressed significantly. But also, if this rate sell off is because of the US being at the forefront of these technological innovations and a re-rating of potential US growth, how much is AI going to participate in that story? There are some economies in Asia, certainly, that are your careers, Taiwan's, Hong Kong's, China's of this world. But in the markets that I tend to look at, which is across to Myanmar and Latin America, the sort of spillovers from AI are much more limited. And I think that's a real challenge, structurally, to the positive EM story that we've been talking about now for the last 18 months. Of course, there are other factors as well. I'll just mention a couple, many of these currencies are now quite overvalued. And on the inflation side, we have had a number of supply shocks, of course, oil prices, which emerging markets tend to be more sensitive as one. But also, climate-induced risks of the El Nino phenomenon this year looks to be rather problematic, and that tends to be quite pro-inflationary. So there are a number of different reasons, as you said, for us to change the view. And outside of these Asian economies, we've definitely become a lot more cautious. So you mentioned El Nino there, Oli. Of course, that's something we know affects emerging markets in particular, given their concentration of food spending. How does that play into the bigger pattern of supply shocks to senior recent years? I mean, they keep adding up Henry, everyone has become experts on crack spreads and refined products because of the issues in the straights of hormones. But of course, Ukraine has become much more aggressive in targeting Russian energy infrastructure this year, which has had a big impact on diesel. I think climate-related risks, anyone sitting anywhere in Europe over the summer, will have realized how real those are becoming. Another issue, I think, which I wrote about in a more thematic piece earlier this week, is supply shocks in the maritime sphere. We've been very used to freedom of navigation, freedom of commerce on the high seas. That's being challenged. I think that paradigm, to some extent, by geoeconomic competition, Russia's ambitions in the Arctic. But also, what President Trump was saying earlier this year about levying a toll in the straights of hormones, that goes directly against. Unclose, which is the legal architecture that underpins freedom of navigation. I think market participants should pay more attention to this risk, because ultimately, you know, tariffs can have economic effects. But when you get these really big physical shortages of commodities, because ports get closed down or you get blockades, that can have even bigger economic impacts, and of course, it's highly relevant to the very disputed area in East Asia around the South and East China seas in the straights of Taiwan. But I mean, I think this feeds into a paper that you wrote quite recently on how the paradigm has shifted, how we should be getting used to much more of a supply rather than demand-driven world. Is that right, Henry? Yeah, so we wrote kind of a bigger picture, think piece for the Deutsche Bank Research Institute. And it kind of struck me, because when I, and I'm short stress as well, we're kind of first studying economics, perhaps, at A-level in the early mid-2010s, it felt as though we were in a world entirely focused on deficient demand, high unemployment, how we used up that spare capacity in the economy. It was effectively almost an unquestioned assumption that if we stimulated demand, the supply would just automatically scale up. I mean, I'm sure we learned about these things like aggregate supply as a binding constraint. But in practice, it felt as though it never did. But in the decade so far, we've been in the 2020s since the pandemic, it's felt as though that world of deficient demand has completely flipped on its head. I mean, only this year, as you mentioned, the biggest economic crisis of the year has been the closure of the straight-up movies at textbook supply shop. Last year, the narrative was completely dominated by tariffs. Again, a supply side thing, not a question of consumer demand. And that, again, feels like a big paradigm shift. And it changes much of the playbook for how policymakers need to approach these issues. There's definitely been a bigger shift away from world of demand efficiency to one of supply again. It feels a lot more like the textbook suggests as opposed to a unique and unusual period in the 2010s. - Well, that's been fascinating. Thank you very much, Holly, for joining us. - It's an absolute pleasure. Thank you for having me. - So we mentioned at the start of the episode that the Bank of Japan were amongst the major central banks to high interest rates last week. And with that in mind, we're extremely lucky to be joined now by Shoki Yamori, our chief fixed income strategist for Japan, who happens to be over from Tokyo this week at a very timely time for all things Japanese markets. Shoki, it's a pleasure to have you with us. - Thank you for having me. - Let's start with last week's meeting, if we may. It's always investing after decades of ultra low monetary policy and rates when the Bank of Japan hikes. Perhaps all the more interesting by a couple of dovish dissenters, but the door being still left open to further rate hikes. From our perspective in FX space, the reaction in the currency seemed a lot larger than in rate space. What were your main takeaways from the meeting and where do you think the path of monetary policy for Japan is heading now? - I totally agree with you. I think the rates markets were pretty set going into the meeting and what. the reaction, the initial reaction after the B.O.J. was pretty much muted and even when the governor was speaking in somewhat hawkish, trying to be hawkish way, I would say the rage markets didn't react, especially domestic markets didn't react as much and given that Japanese were not excited for an investor, especially the European investors doing the press conference time went preactive as well. So on the flip side, I think, on the dollar yen, I think that was more of a key driver in the markets that took tension of investors. So what do you think is well the future path of money policy looks like? I think in your view you've said that you expect them to hike again in January and I know that the bank of Japan and their money policy statements signaled explicitly that they would continue to raise the policy interest rate. What does kind of the long term or rate look like for you? So our economist forecast is 175, two more hikes, one in January and another in April and that's going to be it and the consensus is around two so it's in the range but the interesting thing is that the Japanese tend to think like 175 is the right level but while when I was talking to clients here, many said that to contain say their dollar yen going up, the BOJ needs to hike more and that it's the BOJs role to do it. But it's interesting because being in Japan, it's not the BOJs, we think that it's not the BOJs job to talk about FX, it's rather a minister of finance. So there is some discrepancy in the thinking of how to contain dollar yen and possibly more back in yields going up. So on that topic, on back in yields going up, there's a couple of interesting things that you've written about over the summer one is how US 10 year yields around 5% how that affects the local market and how local investors view JGBs but also this 3% low in 10 year JGBs. Brawnings, could you just give a little bit of a sense of why the 3% level on the 10 year JGBs is so important and what kind of levers could be pulled if the government starts to focus more on long in yields than the yen, for instance. So the reason why people are thinking to 3% is not because that's a certain level that was leveled in history or past but it's just that the Japanese government budget formation is using 3% as a measure for the fiscal year. So for me, I think surgery is going up over 5% and the Fed being more hawkish that could lead to 10 year going higher so that's really the tick and I don't really think that 3% now means a lot if the surgeries are going up fast and strong so that's I just focus on the Fed and the US surgery markets at this moment. And actually one bigger picture question I had for you obviously, where you are, what's your perspective domestically in the sense that clearly, you know, writing here in Europe or in the US, Japan looks like an outlier that they've had ultra low rates for so long, even the 1.25% rate at the moment, that is the highest, it's 1995 and similarly with inflation becoming a more embedded part of the economy again, how is that changing attitudes among the Japanese public? What has shifted in last years? It's interesting that this is just anecdotal but so product, say you have a rice bowl, when you had the inflation, it got smaller, so we call it stills inflation but now producers are just putting on the cost on the products they sell and the difference is that I think the consumers are accepting the fact that they have to absorb that so that that is making a big difference. Interesting, okay, thank you. So moving away from shrink inflation to actual inflation, maybe a little bit embedded in expectation, which was of course part of the policy aim of previous decade to try and restimulate the economy, that's fascinating. Is your sense from your meetings here in Europe so far that there's a big difference in how we are viewing the Japanese market? You've written about the importance of tracking flows and how foreigners have been buyers of JGB's at these levels. Is there a sense from your meetings that there's still going to be an appetite for that to continue even if the Bank of Japan say halt at 1.75 as you mentioned earlier? I think the BOJ is really important but many investors were talking about GPIS and how they could possibly change their allocations and buy more JGB's and repatriate. So I think this theme here is, I mean the BOJ obviously, I think investors know that they will do their stuff, whether that's the terminal radius 175 or 225, that doesn't really matter. I mean, they know that BOJ is going to hike with the Fed and the ECB's. So that part is pretty clear but I think other investors are really focused on other actors like GPIS and like agricultural bank and those kind of people that has the capacity to buy JGB's. So that's really the key discussion and I mean there's no obvious answer but there's been a lot of talks on other investors that could potentially help the JGB market. Yeah, fascinating I think that that emphasis on the flows and the impact that that might have and emphasising that as opposed to necessarily the degree of where terminal rate lands being very important for the JGB, it's something that normally affects that we've also emphasised in our in our recent blueprint in which we've recommended buying the Japanese yen against the euro. Well thank you very much. Thank you. Thank you. Thank you very much. Well that concludes another episode of Rate Check. We look forward to joining you next time. Thank you very much. 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