US Fed and China to give Asian currencies a tough time, says Law of Bank of America

The movement in exchange rates of Asian economies over the past six months has been nothing short of dramatic. The best performing currencies in 2022 turned worst performers as 2023 dawned and resilient outliers came under immense pressure. The trend is unlikely to change this year, says Patrick Law, who heads forex trading for Asia-Pacific at Bank of America. Law believes that the US Federal Reserve’s commitment to rate hikes could make life hard for Asian currencies, including the Indian rupee. “Whenever the Fed aggressively tightens, things don’t go well either for the US or for the world,” Law said in an interview with Moneycontrol.

Volatility is no stranger to forex markets. Between Fed rate hikes pulling dollars back to the US and China’s reopening strategy bringing back the appeal of emerging markets, market participants have plenty of fodder to punt and counter-punt. As for the rupee, the research wing of Bank of America expects it to appreciate to 81 to a dollar by December. Law believes the Indian currency will be governed by seasonal factors. Edited excerpts:

What do you see as the key drivers for the forex market this year?

For this year, there are basically three main drivers impacting the global foreign exchange market. The Fed, the Bank of Japan, and the China reopening story. Since January, till now, these drivers have been impacting the market at different times. In the beginning of the year, the market was more focused on the Bank of Japan and the China reopening story. This is not to say that they didn't care about the Fed, but they expected the Fed to have come very close to the end of the tightening cycle. Therefore, I characterise the movement in January to be more driven by the Asia story. However, in February, there was a strong US labour market report, and a very strong US inflation report. So the spotlight went back to the Fed. By the time we got to March, the market began to embrace the possibility of a much higher Fed fund rate to almost 5.50 percent from the earlier terminal rate of 4.80 percent.

Does that mean that the Fed’s rates will matter more to Asian exchange rates and not their own economy’s fundamentals?

Yes, because this is not a typical year. We are not talking about just a few rate hikes but a range level in the US that is exceptionally high, levels that we haven't seen in more than a decade.

It is not going to be a one-way market, like last year. Last year, it was unidirectional because it was the beginning of a tightening cycle in the US. This year, it is about when the rate hike race will end and where will it end? For Asian currencies, it doesn't look nice. I do think that it becomes harder to call on direction. For the market, there must be an endgame. Most likely in the near term the market will become very concerned about much higher interest rates and that concern can become a little bit overblown as a risk. So the risk is that in the next one to two months, the dollar can stay very strong and Asia in general will be impacted.

What does the China reopening do for the Chinese and other Asian currencies?

China is a large domestic economy, and it also has a very large external sector. We probably cannot just analyse one segment at a time. Simplistically, China reopening would mean consumers will come out and start spending. But if you look at the external sector, you will get a different story. If US domestic demand is going to slow down because of more Fed hikes, then it would hurt the external sector of China. On the other hand, China consumers not only spend locally but also overseas. Chinese may use the money to buy luxury goods in Europe, they go to vacation in Thailand and buy cosmetics in Korea. That is why you see the Thai baht, the Korean won, Singapore dollar and Indonesian rupiah, all rallied back in January. Possibly the market will focus on different things at different times, just like what we've seen from January to March. It would be volatile until we get to a point where we have a clear view of what the Fed may do. I do think that the next few weeks are quite important watching the US data.

Among Asian currencies, which ones could be candidates for resilience? Perhaps because of China’s reopening?

Well, typically you would expect countries with a current account surplus have a cushion for shock. Those with deficits, you cannot just look at the debt in isolation, you also need to look at the valuation. The currencies that benefited the most from the China reopening story back in January were the Korean won, the Thai baht, Singapore dollar, and so on. But these could also turn around quite sharply, because so much optimism was baked into them. Once this optimism begins to fade, the markets shift their focus to something else. So a currency that used to be one of the strongest performers in general now can be one of the worst performers. Countries like India, for example, usually have a current account deficit and are a little bit more vulnerable.  The rupee didn't do very well in January probably because India is not going to be a major beneficiary of a China reopening. But then, in recent weeks, the performance has become better.

The BoJ is in a different league when it comes to central banks. It has a yield curve control policy. How would the recent change in YCC impact the yen?

There are two factors at play together for the yen. One is the removal of the YCC, and the other is the Fed hikes. Most people expect the YCC to be removed some time in the second quarter. Either in April or June. I think most of the clients now feel that if that happens, the dollar-yen may not go down. Or the dollar-yen can go down temporarily but will go back up again. The reasons are twofold. Number one, BoJ’s target rate is still minus 10 basis points. It is unlikely they will change it. Maybe at some point, they're going to move to zero, maybe at the end of this year. But even after the funding rate is zero while the US rate is five and a half. So the Japanese may still invest in foreign currency for higher yield. It seems quite likely that you know the yen would become a funding currency.