US support for the yen and China's inflation exports

Speaker A: Hello and welcome to the Currency Exchange. Now it's Markets FX podcast where we break down the major themes and events driving currency markets this week and in the week ahead. Today I'm joined by Brian Dangerfield, who is our US head of G10FX strategy. And, um, Brian, it was only this time last week they were actually talking about market pricing which really suggested FX intervention in the yen. We have learned a lot in the weeks since. What do you make of the US Treasury's announcement that is prepared to buy in?

Speaker B: Yeah, thanks so much for having me, Emer. So, as you alluded to, you know, we record on Thursdays and last week we were recording in the midst of a very significant move lower in dollar yen. It certainly looks like intervention, um, from Japanese authorities to come in and buy yen, um, and in the time since, we have learned that not only was there ethics intervention, but that treasury decided to join in the intervention and buy yen, um, in order to support its valuation. Now, this is a very significant development. It's not unheard of that treasury would make a move like this. You know, this is the first time in around 30 years that treasury has stepped in in this capacity. There have been previous experiences where we've had joint intervention in currency situations. That's often reserved for, uh, emergency situations. The Fukushima earthquake, uh, is the most common example where central banks jointly stepped in in the yen market, um, around that time, given the scale of the crisis and the scale of the emergency. But Treasury's decision is quite significant and it adds a lot of potential weight to the gravity of the situation with the intervention. So one of the big questions about intervention with, you know, with Japan, with China, with any economy, is how would the US respond? Because the US's position is that intervention should be limited and that central banks should not be interfering with fundamental FX valuations because currencies are inputs into exports and imports. They have implications for international commerce and it has implications for the US financial system when, uh, central banks are taking action in currency markets. So there's been a broad question about if U.S. officials would be against Japanese officials stepping in to support their currency. They gave an emphatic answer to that question. Six months ago, treasury did what we call a rate check in dollar yen, which is they went to the financial market and asked financial markets, if we were to buy the currency, if we were to buy the yen, what level would we get? That's the kind of thing that you only do when you want to give the market a sense that you might actually be preparing to execute a transaction. But in January, there was no execution of buying the yen in this instance. Treasury has since confirmed that they did execute intervention and they bought yen and they did so by selling euros, uh, which is notable considering the euro is not our currency here in the United States. We are of course, uh, dollar denominated here. So it's quite significant that treasury stepped in. It gives the MOF's intervention maybe a vote of confidence from across the Pacific in the United States that it's not only something that the US Isn't frowning upon, but it actually encouraged. Treasury Secretary Besson has since spoken both in US and Japanese media discussing this decision, discussing the conditions for this decision and what, you know, his view on fundamentals. One thing that's very clear is that the US Took this decision to support the Takaichi government in Japan because the Takaichi government is an important ally of the president. Um, whether it be in military. The US Wants Japan to increase its military spending. Uh, they want Japan's support in the Iran war. There's also, uh, expectations around economic strengthening. You know, as we know, there was last year a significant investment commitment as part of the interim, um, trade deal announced last year with Japan, a significant step up in Japanese investment into the United States. And so the US Sees Japan as an important partner. I think that's always been the case. And I think this was a vote of confidence in, from the US Specifically in Takaichi's government, which has been pushing, you know, not to minimize it, but almost more, almost a more maga version of the traditional LDP towards additional stimulus, towards maybe a more, uh, you know, a more defense spending, maybe a harder look at immigration and net immigration. And so they see Takaichi as an ally and I think they stepped in for that reason. The other thing that treasury has been saying is that they believe that Japan needs to implement policies which will allow for more durable support of the yen. So while not specifically said, I think the point that Besset may be making is that he believes, like I think most of the market believes, that in order for the yen to strengthen more durably, it will require the bank of Japan to turn a lot more hawkish. Because the problem for the yen, um, currency for a long time has been its low yielding status has left it as a funding currency for carry trade. So borrowing in low yielding yen and investing in higher yielding assets, having that carrying cost be in your favor, that remains a headwind. It's not something that will go away without meaningful changes in interest rate differential. So that would include things like bank of Japan tightening. Where this runs into a potential roadblock is that the Takaichi government is pursuing her version of Abenomics policy. The Abenomics policy from back in the, uh, early 2000 and tens was centered upon stimulus from the fiscal side, significant stimulus and significant monetary accommodation to allow for that stimulus to be as impactful as possible. And so there are some questions about whether or not the bank of Japan would be ready or able to pivot into a much more hawkish posture to support the currency when the Takah government is in the process of trying to expand fiscal stimulus and perhaps putting some light asset pressure on the bank of Japan not to step in and spoil the party, if you will, to reduce the impact of that, uh, fiscal stimulus. And so Treasury's intervention is certainly notable, but it appears it comes with some strings attached, which is that essence support and the US support of the Japanese currency may require Japan to potentially change policies in order to say, follow through with, uh, policies that the US sees as more consistent with a strong currency. And I think that's really where the rubber meets the road on this intervention. We've seen a significant move lower in dollar yen in the first instance, uh, on Thursday and Friday of last week, significant move lower. But since then we've traded a bit flat here. And I think that may reflect the fact that we have not had a confirmed intervention in a couple of sessions here as we record. Uh, but also the market's understanding that interventions don't change fundamentals and that it would take a bigger change in fundamentals to provide maybe more durable support for the currency here.

Speaker A: And how are you thinking about the yen here? And I guess what do you think of the fundamental backdrop for the currency?

Speaker B: Going right there to the fundamental backdrop is that I think there are still challenges for the yen. The first comes from the bank of Japan remaining, um, relatively slow in its tightening process. There's certainly some speculation now that the weak currency is having a greater impact on their thinking that maybe they would be willing to speed up their pace of interest rate hikes here at NatWest. We think their next hike comes at the October meeting. There's some speculation whether they would pull forward into their next meeting in September. Uh, but one thing to consider is that a stronger currency is one of the things that could buy the bank of Japan time in their tightening cycle. So you think about how it's Almost a catch 22 if you will, that if the yen were weaker than it is right now, maybe they would be more axed to potentially raise interest rates in September. But now that the yen is stronger thanks to the intervention, maybe they have opportunity to remain, uh, a bit more patient in their approach. So one consideration is where does bank of Japan policy come from? Here, the other side of the rate differential coin is the Fed side. We do think that the, uh, Japanese authorities are going to get some help from the US Side because we don't think the Federal Reserve will raise interest rates in September. We think the economic data is going to support that. Now as you listen to this, you'll have seen non farm payrolls, uh, the critical employment report that comes out on Friday. But on the inflation side, we are continuing to expect some moderation in core inflation that might allow the Fed to remain in a more cautious, in a more patient path as well. So we are expecting some, uh, interest rate convergence in favor of Japan. But it's worth highlighting that over the last year and a half, we have seen a spectacular breakdown in the relationship between relative interest rates and in dollar yen, that lower interest rate differential. So higher Japanese yields relative to their US Counterparts has not been a clear driver of stronger yen. If anything, it's been the opposite. And that might reflect markets concern around fiscal policy and concerns around, um, JGBs. And as mentioned, we have significant new fiscal stimulus, the push on the consumption tax. The Takichi government won a massive mandate to cut consumption taxes to support, um, everyday Japanese people. Since that pledge, we have had an energy crisis that has required additional potential spending. And additionally we've had the onset of the U.S. iran War and that has intensified calls from the Trump administration for Japan to increase defense spending. So we have multiple angles of increases in fiscal outlays. And I think the markets are skeptical that the Takahi government will be able to meet their previous pledge to do all of this additional spending without increasing deficit financing via, uh, issuing JGBs. And so there has been concern on the fiscal side that there are going to be an increase in supply of Japanese government securities and that the demand for those securities is not going to be able to keep up. Whether that be because the bank of Japan, who has traditionally been a very large buyer dating back to the yield curve control days, is slowing its pace of, uh, net buying. It's actually run down its balance sheet slightly over time. And there's been some questions over what conditions are needed to have, say, international investors invest more clearly into JGBs. Higher yields help, but they're not the only thing. And then the last question would be, of course, on local investors. Local investors invest a significant amount of their excess savings abroad. And there's been some questions, I think, over whether or not those investors might consider repatriating some of those, uh, foreign holdings in order to buy local assets at these higher yields. I think most believe this is more of a long term story, not something that can happen in the immediate term, uh, that these big investors don't make those kinds of significant allocation shifts. They uh, don't make them lightly, they don't make them quickly. And so I think the market is skeptical that that kind of wholesale change in local investor attitude towards Japanese assets will happen quickly. So I think we take all this together and say we are expecting some further interest rate convergence which would in theory support the yen. But that relationship has been weak and fiscal policy does not appear like it's in a position to change dramatically to address market concerns. Um, and so as a result I think it's still difficult to create a positive fundamental argument for the currency outside of the fact that intervention is providing some temporary support and reducing speculative shorts and, and perhaps reducing investor appetite to be short the yen, um, uh, for the purposes of just collecting carry and for funding higher carry trades. So emer, I want to turn to something, uh, we talked a little bit about China last week, uh, and uh, coming out of the Politburo meeting, um, I want to come back to China here and ask you specifically about something you wrote about this week which I think is so interesting and has such important implications for global policymaking and for global economics, which is China's role in global inflation. This idea of China price inflation is low, but it appears that maybe export prices have gone up and they may be exporting inflation to the rest of the world at a really an opportune time, uh, for, for other central banks and for other uh, countries. How persistent is these signs of maybe increasing export inflation coming from China?

Speaker A: Yeah, I think we've always been used to kind of trying exporting inflation. And actually up until April this year China had been consistently exporting deflation for the last three years. But in April we had this big surge in export price inflation. The timing looked to be the clue here, right? It was right around the time of the Middle east, uh, war and higher energy prices. However, when you compare it to PPI inflation, so basically a measure of factory gate prices, it far exceeded this. So really the implication was that actually Chinese exporters were increasing their profit margins. When we did kind of a sectoral analysis of profit margin growth, we revealed something which we like to call the China export inflation smile. Basically this is kind of the combination of two stories happening at the same time. So effectively on one end of the value added scale production, you've got the very low sophisticated industries, oil and gas, minerals, chemicals, uh, who basically hiked prices, really availing of hotter, uh, higher commodity prices in the aftermath of the Middle east war. To be honest, this looks fortuitous. This is kind of producers kind of cash again on a higher uh, prices for their goods. But the second group was high end manufacturing. This is very much kind of tech advanced AI which have seen incredible increases in industrial profits. And this really looks to be persistent. This is definitely the result of a concerted policy effort and doesn't look like it's going to be washed away anytime soon.

Speaker B: So what do you think has driven this switch to this higher, uh, value Chinese manufacturing? I think this is so important because of how it feeds into not just the AI, uh, the AI trade, but also into inflation. Because it certainly feels like here in the US a big focus has been on this AI boom in computing products and higher prices here. And so what do you think is driving this switch to higher value?

Speaker A: It's definitely a combination of policies and I would say it's both reactionary and proactive. So I think when it comes to reactionary, you've obviously had a more hostile, um, kind of global trading environment when it comes to Chinese exports. So for example, you know, if Chinese car exporters are facing higher tariffs in the EU market, they face two choices. You either stomach those higher costs or you localize production. If you localize production, you end up with a higher cost base anyway. On the domestic side of it, you have kind of Chinese policymakers who are trying to push, um, Chinese producers to kind of move away from this volume led growth to value led growth. They have definitely kind of learned from previous examples that, you know, undercutting your competition, focusing on market share just isn't the way. So we've seen, you know, on one side we've seen the strategic rollback of previous tax incentives which have previously supported manufacturers. We had the VAT tax rebates which have been used since the 1980s to really support manufacturers, and then export exporting into international markets since 2021. So really in the aftermath of that first Trump trade war, systematically China began rolling these back for sectors that were mired in overcapacity and had really seen steep price declines. So steel, aluminium, copper, all of these had their export tax rebates effectively canceled. And now it started for electric vehicle batteries. So by 2027 they'll be completely canceled for this industry. And then another screw of Chinese policymakers are trying to turn against exporters who previously competed on very thin uh, margins and really on a cheap currency is the currency itself. They're orchestrating an appreciation of the yuan. So even if you look over the last year over 2025 you had an over 7% appreciation of the currency. So you're really kind of implementing financial pressure on companies to really scale up that value chain and to no longer compete on volum, but to compete on value which allows you to charge a higher pricing.

Speaker B: So I've alluded to it a couple of times already about potential global implications of all of this. Um, so I want to ask you straight up, um, what are some of the implications globally and also for China from this change?

Speaker A: Yeah, you know, I have to say that China is charging a higher price but for a higher value product. So that in and of itself is not necessarily inflationary. I would say the biggest risk to the world economy is who replaces China. You know, the world has lost it's source of cheap manufactured goods. So who fills that vacuum for the world economy? And I would argue that there's no one else, no other economy that really has that kind of unique centrally planned political architecture that can deploy capital at scale, roll out incentives across tax, across lending across land, uh, ease regulatory requirements to really orchestrate pushes into specific, specific industries that supply the world with very cheap manufactured goods. So I think you know, any alternative to China when it comes to those low value add manufacturing goods will be more expensive and that will be more inflationary for the global economy. When it comes to China, you know, we still have significant deflation risk. I would say in China we've had inflation ease back to 1%. So higher value goods certainly for China does not mean that they're going to get, you know, a surgeons of inflation. Uh, but I think it does mean that you'll continue to see really the currency strengthening further in a moderated kind of paced manner. But you will see more pressure coming on authorities to really appreciate um, the currency and really force those manufacturers to move up that value scale. Brian, that is probably about all we have time for this week. We have definitely covered the main points in Asia. Uh, please do remember if you like the podcast, please do click like and subscribe. See the latest episode first. Thanks for joining.