Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Markets. I'm your host, Tim Graf, head of Macro Strategy for Europe. Each week we talk about the latest insights from our award winning research as well as the current thinking from our strategists, traders, business leaders, clients and other experts from financial markets. If you listen to us and like what you're hearing, please subscribe, Leave us a good review, get in touch. It all helps us to improve what we offer. With that, here's what's on our minds this week.
Our series of research conferences continued this week with a trip to Asia. I didn't go myself, but I caught up with Dwyfor Evans, our head of Macro Strategy in the region, who is in the middle of presenting at a series of conferences, all of which are aimed at helping our clients navigate the current market landscape. And man, is there a lot to navigate. Last week's broadening of hostilities between Iran and Israel adds to a mix of uncertainties arising from US trade policy, US and global fiscal policies, and what all of those factors mean for inflation, growth and the labor market around the world. We spent most of the time especially focused on how likely central banks and governments will aid in the US' aims to keep the dollar weak and long-term US interest rates low in exchange perhaps for greater security guarantees. In so many words, these are the desires underpinning the so-called “Mar A Lago Accord.” Have a listen.
Dwyfor Evans (DE): Tim hello.
TG: Hello.
DE: How are you doing?
TG: I'm good, how are you?
DE: I'm very well.
TG: So talk to me about, you were in Beijing yesterday, I believe. What is the mood from clients in terms of, well, just a lot of the themes, but I guess the more resilient nature of markets the last few weeks, it'd be really interesting to start off with that. And then we'll talk about the Middle east and then we'll talk about dollar Asia.
DE: I think if I think about it from the perspective of Asian clients, there are a couple of things that have really come to the fore. One is obviously around trade. Secondly of course is section 899 of the “Big Beautiful Bill,” whatever it's called, is really creating a little bit of issue out here. Not least of course, because it's an implicit sort of tax on the very high level of capital investments that there are in Asia into US assets. Tariffs are raised continually. Trade obviously matters to Asia. There's been a lot of, I think quite vague talk from both sides actually from the American side and also from the Asian side. Be it the Japanese, Chinese, the Koreans. There hasn't been a lot of clarity around strategy. There hasn't been a lot of clarity around how to ease trade tensions, the timeframe around this and how they're likely to proceed now and beyond the 90 day sort of implementation deadline.
Obviously that leaves people with more questions than answers. The 899 section, what's interesting about this is we talk about tariffs, that's obviously a trade war issue, but actually if we are now also concerned about, I guess, tax on capital and tax on assets, that has the potential to transform what is a trade war into more of a capital war.
And obviously this matters because there are significant dollar reserves within the region. All this does, of course, is it again opens up then the conversation around diversification, diversification away from the US diversification to other asset classes and to other geographies. And of course encompassed with all this as well is just geopolitics because we have domestic squabbles in the US we have the ongoing Ukraine conflict, we have now the Middle Eastern conflict has again sort of broadened and become a bit more, should we say just a little bit more frenetic in the last week or two.
Asia's looking at this from afar. This has significant potential impact on markets, although I probably argue that what we've seen thus far actually from the Middle east has probably had less of an impact than what I would have expected. But still, who knows the direction that this goes in and who knows the extent that this goes into as well. So the tariffs I don't think are going to go away. The capital tax implications, we just wait and see on this because obviously that needs to go through the US legislative system. But geopolitics is a continual factor that people are focused on.
TG: So I think we're going to talk about all of those if we can. This discussion and the reason why I wanted to tap you this week was about the moves in dollar Asia over the last quarter. And I just have a couple of numbers to read out. So quarter to date, the best performing currency on a spot basis, amazingly is the Taiwanese dollar, which is up 12 and a half percent in the quarter. You also have a large appreciation in the Korean one, about 8 percent. And you have other Asian currencies that have also done quite well. Now the dollar has generally weakened across the board this quarter, but in market environments past, and we've done this for a long time, I'm going on about 18 years working in FX and I think you may be a little bit longer than that to have The Taiwan dollar move 12 and a half percent in a couple of years is a big deal. To do it in a quarter is a massive deal.
That is all preamble to what I wanted to talk about mainly which though you mentioned reserves and moving away from dollars and I wanted to see if we could dial things back though and then go back towards the starts of our careers really as to why they have so many dollar reserves.
And then we'll get to talk about why those reserves are coming into focus and why currencies in the region are appreciating. And why are dollar reserves such an important part of the equation for the region?
DE: Takes me back even beyond the beginning of my career, which is probably 25 years now. The Asia crisis is often considered some sort of starting point here. Just looking at Asian FX reserves, even if I start in the year 2000 and I compare it with 2010, Asian FX reserves basically went from about 500 billion to about 3.8 trillion. So in that just one decade, in the sort of 10, 12 years after the Asian financial crisis, we basically had a sevenfold increase in reserves, probably to excessive levels. But those excessive levels have not in any shape or form reversed in the subsequent sort of 15 years or so. We've basically gone from nearly four trillion now to six and a half trillion. So this has been an ongoing build of FX reserves within Asia. And let's not dwell too far on sort of history here, but the Asian crisis was really a classic sort of EM catch up growth story. I mean we don't talk about this term anymore, but Asian Tigers was a term that was thrown around continually at that particular time. The integration of Asia into the world economy.
Japan I guess kicked this off 50s and 60s, Korea, Taiwan sort of built on this in the 80s and then of course that spread to the rest of the region. Then throughout the 90s that catch up of growth and that integration of Asia into the world economy had a number of implications. The first one of which was sky high investment rates into Asia. Significant hot money inflows and dollar pegs certainly were the norm within Asia. As with everything else, of course, you know, you reach the top of the pyramid, then something cracks and the whole system sort of breaks. What we had at that time was effectively an Asian capital account crisis rather than anything that was related necessarily to the current account. And so what's happened since particularly through the 2000s, hence the numbers I gave earlier on this significant near sort of exponential rise in FX reserves, what's happened since through the 2000s is that Asia in particular, capital account liberalization has been far, far slower and more controlled to discourage short term flows, particularly obviously outflows.
And of course China is very much the poster child for this. Plans around liberalization that we've had in China have been pushed back quite frequently. But other countries are the same as well. Other countries are exactly the same. When we think about Korea, Malaysia, Thailand, over the course of the last 10 or 15 years, financial reforms, strengthened supervision, regulation, these have become sort of bywords for how Asia now manages capital flows. When you think about how Asia's developed since then, the current account surpluses, which is ultimately, when we think about the trade balance, when we think about current account savings levels in the reach are very high. The consequence of that is that you don't get a great deal of consumption and it's of course then led to a dependency on more export led growth. And then the export led growth has basically accounted for much of the trade surpluses that we've seen over the last 20 years. And the upshot of that of course is this consistent accumulation then of reserves. That accumulation of reserves obviously converted then into hard currency, that is your FX reserves in a bid to try and keep regional currencies competitive.
TG: And that. Yes, so that is exactly the point I was trying to allude to in terms of the spot movements in FX that we've seen recently. The timing of them as coming amidst a trade war that the US has really instigated, but done so potentially with pretty solid grounding insofar as the accumulated surpluses that you've gone through and how that happens is a consequence, at least from the US's perspective. And this is, this came up a lot and has done throughout our career in terms of labeling other countries currency manipulators because of their persistent surpluses, be they bilateral versus the US or in aggregate relative to the world, is a consequence of the perception at least, that the currencies in the region are undervalued and you've gone through the capital account side of things. But of course you've then finished with the trade side of things, which is really the corollary of the capital account. It has a balance.
How deliberate would you say these economies were keeping currencies undervalued as part of building reserves and encouraging the bulwarks against future capital flight?
DE: There's this sort of circular process I think is true for China, has been historically true for Japan, is true for Korea, it's true for Taiwan, particularly North Asia, maybe less so than South Asia, but I would probably Argue that even the likes of Singapore and maybe even Thailand as well, have fallen into this sort of circular process over the years, which is that you have very large productive capacity, but you don't have a sufficient amount of domestic consumption. And so you have an excess of capacity. And so your only option therefore is to increase or at least support or subsidize best you can, your external sort of demand and external demand conditions.
What this effectively means then is that this currency management is inbuilt within North Asia in particular in terms of maintaining exporter competitiveness. And so when you think about the likes of China with a very sort of strict daily sort of move in terms of its currency, and when you think about currency management in places like Korea and places like Taiwan, this mercantilist approach to FX that these countries actually have, effectively their key policy objective is to try and maintain relative competitiveness within the region. The challenges for Asia at this particular point is obviously all the trade and the tariff uncertainty. And if we think about that in the context of global trade volumes, this is now potentially leading to, you know, potential sort of growth, growth downgrades for Asia relative to the rest of the emerging market world and indeed relative to the rest of global markets in general, given how dependent they are on trade. And obviously any, any particular downswing on or downgrade on global aggregate demand will have more of an impact on Asia than it does elsewhere.
TG: The question then is, especially in light of what you've brought up, which is a really good point, I think, the notion of regional competitiveness, not just a cheap currency versus the dollar, but regionally as well.
Why do we see these moves that I started this segment with in terms of the big move in the Taiwanese dollar or the Korean won? Why is that happening and why is it happening now?
DE: Two things have obviously happened here. The first thing is since the inauguration, the election is one thing, but the inauguration is when policies are really set in stone in terms of what the administration is doing. But since the beginning of the year, it's been pretty clear that the trade and tariff policy lever is one that this US administration is hell bent on pursuing. And that's come at a time as well, of course, when the dollar has weakened for various sort of reasons. Now, again, there are concerns here about the security of foreign assets in the US you know, the US exceptionalism story doesn't seem to have as much weight today as it did do maybe six or 12 months ago.
And so that's part of the story as well. Is the dollar weakness story allied to concerns that realistically currency will have to be part of some agreement with the US, so the US has actually called out Asia on multiple occasions as potential currency manipulators. So this is not something new. Some of them, I mean Korea and Taiwan in particular, stand out as having very sizable trade surpluses with the US it's very naive, I think, to believe that the region will be able to avoid any sort of trade discussions without some emphasis on bilateral currency rates.
And it's coming at a time when global markets more generally have turned against the dollar and have turned against US assets. And in line with dollar weakness, you tend to see that the negative relationship between the dollar and the EM is well centered by now. When the dollar is strong, EM currencies generally tend to be weak and vice versa. So if you're in an environment where the dollar is weakening, then EM currencies will tend to strengthen. But of course, what happened was it looks as if many of the investors overseas really did not foresee this dollar weakness in terms of their hedging policies.
There is somewhat sort of forced buying here based on the hedging strategies and the hedging policies that investors have had over the last few years in anticipation, presumably that they expected the dollar to strengthen and to continue strengthening. And that was realistically most people's year ahead view still at the end of 2024, early 2025, which obviously hasn't been borne out in reality.
TG: So what does this mean for policymakers near term thinking both about currency policy as well as perhaps monetary policy in response to all of this, in an anticipation of potential tariff negotiations?
DE: Okay, now, let's go back to President Trump. Let's go back to his five decade 1980s. I think he started talking about his five-decade-belief that Asia is stealing American jobs and prosperity via weaker currencies. So that's a sort of starting point. So this an option now of course, is potentially some sort of new regime for Asia. Asia will now not follow the Fed necessarily in cutting rates in the second half of this year, even if the Fed question marks about how much the Fed can actually cut rates in the second half of this year, that Asia may not follow simply because they want to maintain stronger currencies and subsequently maybe allow for currency appreciation partly to close some sort of perceived valuation discount, but also to draw down some of the massive sort of current account surplus that you see in some of these markets. And that as effectively, as effectively a bargaining tool with the US to, to, to, to ensure that now trade tariffs are kept at whatever minimum they would be in terms of the percentage of explicit tariff.
TG: So this gets to notions that were put forth in a paper that is now called the “Mar a Lago Accord” or it's referred to as the “Mar a Lago Accord,” where ultimately I'm not going to go into the details for people listening, but basically there are contradictions within it. It's somewhat self-contradictory, but in fact the aims of it basically equate to a weaker dollar. Particularly I would say, you know, the goal being against Asia in particular, which okay, tick. But also the idea that the large reserve managers, again mostly in Asia, Japan and China in particular, but also Taiwan and South Korea as large components of that as well, continue to fund the US and not just fund the US but agree to term out the funding and keeping the cost of US funding lower.
Now we've talked about the currency side, or you've gone through the motivations to maybe revalue, but you also bring up the notion of losing American exceptionalism and US assets being maybe less attractive to hold. Is there any sense of evolving towards an informal adoption of this “Mar a Lago Accord” by those reserve managers in the region actually taking that step? And whether it's a formal commitment or just somewhat like what they've done with the currency, implicitly saying yes, okay, we acknowledge maybe our currency is a little undervalued. We will also help you, the US in terming out our asset structure a little bit and suppressing or helping to suppress long term US rates.
Do you think they will be reserve managers in the region that is as amenable towards something like that?
DE: Possibly. However there is. So you mentioned a few minutes ago that there is an inherent sort of contradiction and in some instances not fully consistent in terms of the thinking here. In my opinion, from the US perspective, the way I think about it is this if part of the agreement. Let's think about it now in terms of the agreement of a weaker dollar and stronger Asian currencies. What you get is to the point I made earlier, lower trade volumes, maybe globally, then you end up with lower surpluses in Asia. Your reserve accumulation in Asia slows as a consequence. We've started to see that already there has been a slowdown in Asian FX reserve accumulation in the last three to six months or so. Lower reserve accumulation, lower savings, whatever you want to call it. Bottom line is fewer resources with which to invest in global assets such as Treasuries. So coming back to the point earlier, going back again to the big beautiful Bill, this section 899, if this is creating some sort of scope for the US Administration to transform a trade war also into some sort of capital war. The more that the U.S. administration weaponizes the dollar in this way, then the more other countries are at least able to diversify due to geopolitical reasons.
And obviously this matters in Asia, given the amount of aggregate reserves and U.S. demand, not least within US treasuries. So that's the risk here, is that a weaker dollar, stronger Asian FX, fewer reserves to buy US Treasuries, and then that has to become part of the negotiation between the US and, and the Asian authorities is how do you deal with weaker overseas demand for your underlying assets and what do you give the Asians in return? If you're effectively saying I'm going to weaken the dollar, strengthen your currency and by strengthening your currency and my weakening of the dollar, the big macro picture here is that you're going to have lower surpluses and fewer reserves. But those fewer reserves that you have, I still want you to invest in the US I still want you to invest in US paper. Is that a given that Asian central banks or Asian authorities would do that? I would imagine no way would the Chinese necessarily agree to this. And obviously that's a rather important part of the whole sort of Asian story here. It might be different for the likes of the Japanese and the Koreans. The security angle from a North Asian standpoint is not one where I'm getting absolute guaranteed support from the US in terms of my regional security position compared to what I've been say over the last five, 10, 15, 20 years.
So there has to be a bit of give and take there. So I guess what the US administration would like is continued overseas purchases of its assets. But I think it's going to have to give something in return as well. And that give will probably have to be something that is sort of non-economic, some sort of security implications or some sort of security agreements. But it's not a given because again, the risk here is cost. This is something we've spoken about before with respect to some of the work that we've done at State Street. If global reserve managers are not buying US Treasuries, who is going to buy them and at what price? So this is where this becomes quite interesting. If there is now concern potentially about who the ultimate marginal buyer of US Treasuries will be or US paper, and if yields rise as a consequence, let's think of long end yields rising, continuing their recent rise, there comes a point surely where the pickup in long end yield in the US actually ends up becoming a positive for the dollar again.
And then that potentially changes the whole dynamic of the bigger dollar picture. But also the bilateral rates between the dollar and Asian currencies, in which case we might sort of becoming all the way back to square one, which is that, well, do you expect Asian currencies to strengthen in an environment of dollar strength, which is something we don't tend to see. And then if Asian currencies start to come under some pressure again in terms of weakening pressure in the midst of renewed dollar strength, then we're sort of coming full circle back to where we've been or where we've come from, which is that dollar strength equating to emerging market currency weakness. Now, breaking that particular relationship will obviously be a real change of regime.
TG: And that's actually that leads me to the final question I wanted to ask on the currency side of things before we go to one final topic, which is how much more Asian currency strength can we expect here? I mean, it does seem as though to a degree, with all the things we've talked about, the strength we've seen in the Taiwanese dollar and the Korean one, the last quarter in particular is a response to tariffs and moving a bit towards Trump's position. So saying, right, you have a point. We can do this on our side if you back off on tariffs.
The notion that we are now three weeks away or thereabouts from understanding or having a better understanding or further information, let's say, about what Trump's thinking on tariffs is how much regional FX appreciation would you expect from here? You know, we've kind of talked about this as being the reverse Asia crisis, where now all the currencies are appreciating.
How much further do you see this going, particularly in anticipation of what Trump's response or continued response on the tariff front might be?
DE: Regional currencies are not really that expensive, to be honest with you. If we just think about an age old view of valuations on currencies, it's not as if regional currencies are that expensive. We certainly look at other regions and other currencies within the EM space as being far more overvalued than Asian currencies. I think much of it probably has to do with capital flows. We come back to this again. The real money flows that we have seen at least have tended to favor Asia over the rest of the emerging market space. Now, just because you get capital flows coming into Asia doesn't necessarily mean currency strengthen, but it's at least supportive for further currency strength.
There is so little clarity on how the trade tariff negotiations are going to play out and what the impact will be post the 90 day implementation sort of deadline, which is early July, whatever July 8, I think it is. Beyond that it's still a little bit of a black hole in terms of how this plays out. Those exporter driven economies, for the sake of, I guess their own safety right now, pre negotiations or even during negotiations probably have to be seen to be supporting appreciation of their currencies. I think they have to do that and I think even the Chinese have recognized that there are benefits to maintaining stability in the currency because it just gives them another string to their bow when it comes to sitting down opposite their US counterparts in some sort of negotiations.
However, however those are played out. So I think there is a bit more appreciation bias within Asian currencies. Positioning is not particularly overly stretched. Valuations are not overly stretched. Capital flows are strengthening. Again, there obviously is the still the weaker dollar. Policy seems to be still in train dollar flows that as we can track them are still dollar selling. The dollar is still quite elevated. It's come off, it's come off its highs but it's still quite elevated. So dollar weakness from here is not a given. But there's still the potential here for the dollar to weaken in the face of I guess US uncertainty on the back of that Asia can still appreciate over the near term.
TG: One final topic and it's, I mean we could have done a podcast all on the Middle East this week and I do want to talk about the particularly the regional response to it because as we've alluded to a couple of times throughout our discussion, these are energy importers who use, you know, transform energy inputs into an export led growth model. They are implicitly tightening monetary conditions through stronger currencies and as you mentioned before, perhaps being more reticent to ease policy on the rate side to maintain capital competitiveness and money coming into the region, but also to be seen as helping the US achieve its policy aims.
And so how complicated does the outbreak of hostilities over the last week make things for policymakers? Or is this something as a risk that they have to just look through in the name of pursuing bigger aims?
DE: Yeah, I think they have to look through it for now realistically the point here, which I think is ultimately the way that certainly central banks in the region and look central banks tend to work very closely in the region with governments. There's not a huge amount of central bank independence within Asia. They're pretty tied to the hip actually so if you think about Asian authorities more generally, be they government or central banks, the tightening of monetary conditions actually makes sense given clearly the potential inflation risks. Inflation risks are relatively sort of low within Asia.
But at the same time, the point that I made potentially here for rate cuts out of central banks within Asia right now look very, very low. The concerns will be mostly, of course, given that all bar very, very few regional markets are energy importers. But it does have an impact in terms of your underlying sort of costs. The one good thing about it, if you're calling it a good thing, but one of the one good thing about it, you can partly sort of offset some of the deflation fears that are coming out of China. Deflation fears that are coming out of China are potentially having quite a negative impact on the rest of the region as well. Not least, I guess you got the factory gate deflation out of China. That's having an impact in terms of the persistent overcapacity in China and what that effectively means in terms of production and subdued domestic demand in China. That China deflation story is not particularly good for the region as well.
So it's not that a little bit of inflation is necessarily good for the region. But for now at least, I think that the authorities within Asia will probably have to look through this. If there's a more substantive impact on underlying energy prices, that becomes a slightly different story. But I think we need to wait and see a little bit on that because again, Asian central banks, Asian governments, they are very slow moving, they don't tend to whip around in terms of policy adjustments. So I think that they, they'll be, they'll be content to just wait and see on this one for now. But watch this space as to how.
TG: This plays out very much we wait, we watch, we hope for the best. But you have taken us, I think, around the world. We can't really ask much more of you than that. So thank you as always for your time and, and for coming back and it's, it's a very timely podcast and one I think covers a lot of really relevant ground. So thank you for that.
DE: Thank you, Tim. Good to speak to you.
TG: Thanks for listening to Street Signals. Clients can find this podcast and all of our research at our web portal, Insights. There you'll be able to find all of our latest thinking on markets where we leverage our deep experience in research on investor behavior, inflation, media sentiment and risk, all of which goes into building an award winning strategy product. And again, if you like what you've heard, please subscribe wherever you get your podcasts and leave us a review. We'll see you next time.
