Soaring US Dollar Raises Alarm as China, Japan Escalate FX Pushback

Authorities in China and Japan are stepping up efforts to defend their currencies against a surging dollar that threatens to fan inflationary pressures.

(Bloomberg) — Authorities in China and Japan are stepping up efforts to defend their currencies against a surging dollar that threatens to fan inflationary pressures.

Japan on Wednesday issued its strongest warning in weeks against rapid declines in the yen, with its top currency official saying the nation is ready to take action amid speculative market moves. Shortly after, China’s central bank offered the most forceful guidance on record with its daily reference rate for the yuan, as the managed currency weakened to a level unseen since 2007.

Both currencies have been under pressure from broad dollar strength over the past few months. The yen has slumped by nearly 8% versus the greenback since mid-July, while the yuan is down more than 6% since May.

Indications of US economic resilience are persuading some traders that the Federal Reserve will keep interest rates higher for longer. That’s helped lift the Bloomberg Dollar Spot Index by around 5% since a July low, while a gauge of Asian currencies has plumbed its lowest since November.

These moves are emboldening policymakers in the region — who spent last year burning through their reserves to support local currencies — to head back to the battlefield to take on bearish speculators.

“The prospect of higher-for-longer US rates is reigniting pressure, and investors will be cautious,” said Vijay Kannan, a macro strategist at Societe Generale SA in Singapore. 

Elevated oil prices have also reignited fears over higher inflation, a move that’s undermining expectations Asian central banks were done hiking interest rates and hurting the appeal of local-currency bonds. China’s dire economic outlook, which was built on data have been disappointing for months, is also weighing on sentiment in emerging-market currencies.

“Specifically, EM Asia is more vulnerable to this dollar strength, given a much lower interest-rate differential and a greater exposure to a weaker China growth outlook,” Kannan said.

Signs are emerging the dollar has room to extend gains if bets against the currency— steadily amassed as it weakened earlier this year — are suddenly reversed. According to CFTC data, long non-commercial futures positions are near their lowest level in more than two years.

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The yen and yuan are among the worst performers among Asian currencies this year. While Japan has stopped short of using more aggressive tools to support its currency, China already sought to bolster the yuan by asking state-owned banks to sell dollars while tightening liquidity offshore to squeeze short currency bets.

Similar currency defense measures exist elsewhere in Asia. Taiwan’s foreign exchange reserves declined in August for the first time in nearly a year, as the monetary authority intervened in the market. And in Thailand, the central bank has warned that rapid moves in the baht will prompt intervention.

Still, skepticism remains whether these measures are game changers in the absence of a less hawkish Fed or a pickup in China’s economy. Morgan Stanley turned bearish on emerging market currencies this week, saying those in Asia will be exposed to a China growth slowdown.

“The immediate implication of the soaring US dollar is that it will prevent most Asian central banks from loosening monetary policy, out of fear of aggravating currency weakness,” said Alvin T. Tan, head of emerging-market currency strategy at RBC Capital Markets in Singapore. 

The Bloomberg Dollar Index was little changed on Wednesday. Against the yen, the greenback fell 0.3% after Japan’s currency warning.

Dollar strength has also weighed on European currencies, with the euro and the pound dropping to their weakest levels since June on Tuesday, on the view that central banks in the euro zone and the UK may need to cut rates faster than the Fed as their economies suffer the impact of higher borrowing costs.

In Europe, a broad mix of investors led by real money names have been flocking to the dollar this week, having been largely sidelined since late July, according to traders based in the region familiar with the transactions, who asked not to be identified because they aren’t authorized to speak publicly.

–With assistance from Ruth Carson, Neha D’silva, Naomi Tajitsu and Vassilis Karamanis.

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