Intro

Investors were caught off guard last week when the Taiwanese dollar surged to a multi-year high. Our strategists Michael Zezas and James Lord look at what was behind this unexpected rally.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income Research and Public Policy Strategy.

James Lord: And I'm James Lord Morgan Stanley's, Global Head of FX and EM Strategy.

Michael Zezas: Today, we'll focus on some extreme moves in the currency markets and give you a sense of what's driving them, and why investors should pay close attention.

It's Thursday, May 8th at 10am in New York.

James Lord: And 3pm in London.

Michael Zezas: So, James, coming into the year, the consensus was that the U.S. dollar might strengthen quite a bit because the U.S. was going to institute tariffs amongst other things. That's actually not what's happened. So, can you explain why the dollar's been weakening and why you expect this trend to continue?

James Lord: I think a big factor for the weakening in the dollar, at least in the initial part of the year before the April tariff announcements came through, was a concern that the U.S. economy was going to be slowing down this year. I mean, this was against some of the consensus expectations at the beginning of the year.

In our year ahead outlook, we made this call that the dollar would be weakening because of the potential weakness in the U.S. economy, driven by slow down in immigration, limited action on fiscal policy. And whatever tariffs did come through would be kind of damaging for the U.S. economy.

And this would all sort of lead to a big slowdown and a kind of end to the U.S. exceptionalism trade that people now talk about all the time. And I think since April 1st or April 2nd tariff announcements came, the tariffs were so large that it raised real concerns about the damage that was potentially going to happen to the U.S. economy.

The sort of methodology in which the tariff formulas were created raised a bit of concern about the credibility of the announcements. And then we had this constant on again, off again, on again, off again tariffs. That just created a lot of uncertainty. And in the context of a 15-year bull market of the dollar where it had sucked enormous amounts of capital inflows into the U.S. economy. You know, investors just felt that maybe it was worth taking a few chips off the table and unwinding a little bit of that dollar risk. And we've seen that play out quite notably over the last month. So, I think it's been, yeah, really that those concerns about growth but also this sort of uncertainty about policy in general in the context of, you know, a big bull run for the dollar; and fairly heavy valuations and positioning. Those have been the main issues, I think.

Michael Zezas: Right, so we've got here this dynamic where there are economic fundamental reasons the dollar could keep weakening. But also concerns from investors overseas, whether they're ultimately founded or not, that they just might have less demand for owning U.S. dollar denominated assets because of the U.S. trade dynamic. Now it seems to me, and correct me if I'm wrong, that there was a major market move in the past week around the Taiwanese dollar, which reflected these concerns and created an unusually large move in that currency. Can you explain that dynamic?

James Lord:  Yeah, so we've seen really significant moves in the Taiwan dollar. In fact, on May 2nd, the currency saw its largest one-day rally since the 1980s, and over two days gained over 6.5 percent, which for a Taiwan dollar, which is pretty low volatility currency usually, these are really big moves. So in our view, the rally in the Taiwan dollar, and it was remarkably big. We think it's been mostly driven by Taiwanese exporters selling some of their dollar assets with a little bit of foreign equity inflow helping as well. And this is linked back to the sort of trade negotiations as well.

I mean, as you know, like one of the things that the U.S. administration has been focused on currency valuations. Historically, many people in the U.S. administration believe the dollar is very strong. And so there has been this sort of issue of currency valuations hanging over the trade negotiations between the U.S. and various Asian countries. And local media in Taiwan have been talking about the possibility that as part of a trade negotiation or trade deal, there could be a currency aspect to that – where the U.S. government would ask the Taiwanese authorities to try to push Taiwan dollar stronger.

And you know, I think this sort of media reporting created a little bit of a -- well, not just a little, a significant shift from Taiwanese exporters where they suddenly rush to sell their dollar deposits in to get ahead of any possible effort from the Taiwanese authorities to strengthen their currency. The central bank is being very clear on this.

We should have to point this out that the currency has not been part of the trade deal. And yet this hasn't prevented market participants from acting on the perceived risk of it being part of the trade talks. So, you know, Taiwanese exporters own a lot of dollars. Corporates and individuals in Taiwan hold about $275 billion worth of FX deposits and for an $800 billion or so economy, that's pretty sizable. So we think that is that dynamic, which has been the biggest factor in pushing Taiwan dollar stronger.

Michael Zezas: Right, so the Taiwan dollar is this interesting case study then in how U.S. public policy choices might be creating the perception of changes in demand for the dollar changes in policy around how foreign governments are supposed to value their currency and investors might be getting ahead of that.

Are there any other parts of the world where you're looking at foreign exchange globally, where you see things mispriced in a way relative to some of these expectations that investors need to talk about?

James Lord: We do think that the dollar has further to go. I mean, it's on the downside. It's not necessarily linked to expectations that currency agreements will be part of any trade agreement. But, we think the Fed will need to cut rates quite a bit on the back of the slow down in the U.S. economy. Not so much this year. But Mike Gapen and Seth Carpenter, and the U.S. economics team are expecting to see the Fed cut to around 2.5 per cent or so next year. And that's absolutely not priced. And, And so I think as this slowdown – and, this is more of a sort of traditional currency driver compared to some of these other policy issues that we've been talking about. But if the Fed does indeed cut that far, I do think that that's going to put some meaningful pressure on the dollar. And on a sort of interest rate differential perspective, and when we look at what is mispriced and correctly priced, we see the Fed as being mispriced, but the ECB is being quite well priced at the moment.

So as that weakening downward pressure comes through on the dollar, it should be reflected on the euro leg. And we see it heading up to 1.2. But just on the trade issue, Mike, what's your view on how those trade negotiations are going? Are we going to get lots of deals being announced soon?

Michael Zezas: Yeah, so the news flow here suggests that the U.S. is engaged in multiple negotiations across the globe and are looking to establish agreements relatively quickly, which would at least give us some information about what happens next with regard to the tariffs that are scheduled to increase after that 90 day pause that was announced in earlier in April. We don't know much beyond that.

I'd say our expectation is that because the U.S. has enough in common in terms of interests and how it manages its own economy and how most of its trading partners manage their own economies – that there are trade agreements, at least in concept. Perhaps memorandums of understanding that the U.S. can establish with more traditional allies, call it Japan, Europe, for example, that can ultimately put another pause on tariff escalation with those countries.

We think it'll be harder with China where there are more fundamental disagreements about how the two countries should interact with each other economically. And while tariffs could come down from these very, very high levels with China, we still see them kind of settling out at still meaningful substantial headline numbers; call it the 50 to 60 per cent range. And while that might enable more trade than we're seeing right now with China because of these 145 per cent tariff levels, it'll still be substantially less than where we started the year where tariff levels were, you know, sub 20 per cent for the most part with China.

So, there is a variety of different things happening. I would expect the general dynamic to be – we are going to see more agreements with more counterparties. However, those will mostly result in more pauses and ongoing negotiation, and so the uncertainty will not be completely eliminated. And so, to that point, James, I think I hear you saying that there is potentially a difference between sometimes currencies move based on general policy uncertainty and anxieties created around that.

James Lord: Yeah, that's right. I think that's safer ground, I think for us as currency strategists to be anchoring our view to because it’s something that we deal with day in, day out for all economies. The impact of this uncertainty variable. It could be like, I think directionally supports a weaker dollar, but sort of quantifying it, understanding like how much of that is in the price; could it get worse, could it get better? That's something that's a little bit more difficult to sort of anchor the view to. So, at the moment we feel that it's pushing in the same direction as the core view. But the core view, as you say, is based around those growth and monetary policy drivers.

So, best practice here is let's keep continuing to anchor to the fundamentals in our investment view, but sort of recognize that there are substantial bands of uncertainty that are driven by U.S. policy choices and by investors' perceptions of what those policy choices could mean.

Michael Zezas: So, James conversations like this are extremely helpful to our audience. We'll keep tracking this carefully. And so, I just want to say thank you for taking the time to talk with us today.

James Lord: I really enjoyed it. Looking forward to the next one.

Michael Zezas: Great. And thank you for listening. If you enjoy the podcast, please leave us a review wherever you listen to the podcast and share Thoughts on the Market with a friend or colleague today.