JP’s Journal: A revival in US dollar strength

Large currency moves are often the precursor of market volatility. What we are seeing at the moment is a significant depreciation of the Japan yen against a strong US dollar. In the early 1980s you got 250 yen to the dollar; 10 years ago, you got 75, while at the beginning of 2021 it was nearer 100.

Today you would receive 130 yen for your dollar, representing a near 30% depreciation in 15 months. Why is this happening? The answer may be pretty simple: while other major central banks are talking about raising interest rates or implementing Quantitative Tightening (i.e., selling bonds back into the market) the Bank of Japan remains committed to keeping 10-year yields below 0.25% through unlimited bond buying. Looked at another way, whilst US 10-year yields have risen from a low of 0.5% in Q3 2020 to nearly 3%, the Japanese equivalent has moved up just 20 bps.

Unlike other economies, Japanese inflation remains low. Yes, it has risen but from a deflation rate of 1% to inflation of just over 1% presently. However, contrasted with inflation rates at around 7-8% in other G7 economies this is a remarkable outturn. Japanese consumers appear much more price conscious and Japanese companies are finding it more difficult to pass on higher costs. Of course, this may change but with an ageing demographic profile and weak household spending, it is likely that inflation will remain significantly below that of other major economies. And this is important. It will mitigate the effect of tightening by the Federal Reserve (Fed) and European Central Bank (ECB). This is not great news for the yen but will help cushion the impact on bond yields. What is unknown is the wider consequences for financial markets.

Another currency under pressure has been sterling. Although well above the post-Brexit low the pound has fallen from 1.42 US dollars in mid-2021 to 1.25. There has been little change in the sterling / euro rate over five years, indicating that what we are seeing is US dollar strength, but there has been a downward shift against the euro in recent weeks.

Challenging UK backdrop

This reflects some challenges that the UK economy is facing. While less exposed on the energy front than European peers, the impact of Brexit is becoming clearer on supply chains and labour markets. Despite reassurances that Brexit would lead to renewed entrepreneurial vigour and a bonfire of regulation the opposite seems to be the case. The government has lost faith in its own beliefs (assuming there is a coherent philosophy behind the rhetoric).

The instinct seems to be more regulation – not less – as exemplified by the ridiculous decision to have a football regulator. Czars and regulators seem to be proliferating. The Prime Minister threatens to privatise the Passport Office as a kind of threat, rather than a sound private sector solution that would benefit from competition. But where the government does propose privatisation to encourage competitiveness, its policy would see Channel 4 move from being positively unique to blandly competing with the likes of Netflix – whose single strategy subscription business is showing its weakness. Policies such as Council Tax rebates are poorly targeted if my personal circumstances are representative.

There should be some good news as we move into 2023, with inflation coming down, but the growth picture continues to get worse. The timing of the next general election does not look good for the Conservatives. Without the divisive leadership of Jeremy Corbyn, the Labour party will be in a much stronger position – both outright but also as a coalition partner for others. My view is that the next government will be a Lab / Lib coalition.

On the data front the news was mixed. The US economy recorded a contraction, with real GDP in Q1 unexpectedly falling by 1.4% (annualised). Importantly, this was not driven by falls in consumer spending or fixed investment but rather by slower growth in inventories and a big trade deficit: US import growth was strong while export growth was weak. More positively, US business survey data is consistent with pretty robust growth. Overall, despite the growth headlines, the data will not stop Fed tightening this week. The Bank of England will also go ahead with a rate hike but they seem much more concerned about the growth outlook than the Fed.

Bond markets

US 10-year yields moved higher last week – nudging towards 3% again. US real yields continued to increase with the 30-year TIP at 0.4%, or 60bps higher in six weeks. Conversely, UK rates eased a bit and implied inflation moderated, although the syndication of a 50-year index linked bond was likely the main driver. It was probably the first time in UK financial history where a UK government bond was sold at more than £100 below its original issue price.

Credit spreads continued to widen over the week. In sterling, non-gilt spreads are now 40bps wider on the year and in parts of the market, notably banks and insurance, new issue premia are repricing the secondary market in a material way. Recent senior issues from Goldman Sachs and Wells Fargo have seen spread concessions of 25bps or more. High yield spreads also moved higher but remain below recent wides.

I think we are in for testing times in the next few months. The situation in Ukraine seems to be heading towards 'attritional' warfare, with the no prospect of an imminent resolution. Some countries are experiencing rampant food inflation and are clamping down on exports of essentials. In financial markets the tug of war between 'inflationist' and 'recessionist' is gaining traction. Again, I would reiterate my view that portfolio diversification is vital. Don’t put your eggs in one basket – whether that is an asset class or a credit sector strategy.

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