Biden’s Asian bankers forecast $3.5 trillion margin call

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As US Treasury yields climb towards 5%, Asia is experiencing more than a touch of PTSD.

The post-traumatic stress disorder experience in question is the regional financial crisis of 1997-1998, precipitated by the rise of the dollar. This episode, like today’s, came amid aggressive tightening by the Federal Reserve.

The resulting surge in US Treasury yields shook Asia deeply. Over time, the peg of the currency to the dollar has become impossible to defend. First, Thailand let the ankle break. Then Indonesia, followed by South Korea. Malaysia, too, has been pushed to the brink of economic collapse.

Today, Jerome Powell’s Fed is raising interest rates with the same force as Alan Greenspan’s Fed nearly 30 years ago. This pushed 10-year US Treasury yields to 4.1%. With inflation twice as high and a US national debt over $31 trillion, can 5% returns really be that far off?

As the market nears that threshold, Asia has an estimated $3.5 trillion problem on its hands. This is the value of US Treasury bonds on which Asian central banks sit. Japan and China hold about $1 trillion each, with another $1.5 trillion split between Hong Kong, India, the Philippines, Singapore, South Korea, Taiwan and elsewhere.

US ten-year yields would hit Asia in four ways. First, gigantic fiscal losses as yields rise leave Asian governments with epic losses. Second, significantly higher rates spell disaster for export-driven Asian economies. Third, confidence would be collateral damage when investors flee. Fourth, the fallout from a major pivot away from the dollar by Asian central banks.

The latter risk has been on investors’ minds since the Lehman Brothers crisis in 2008. In 2009, then Chinese Premier Wen Jiabao said that Beijing was “concerned about the safety of our assets” and urged the United States “to honor its words, to remain a credible nation and to ensure the safety of Chinese assets”.

Two years later, in 2011, S&P Global Ratings argued Wen by revoking Washington’s AAA status. The question now, as inflation soars, debt rises and US political polarization deepens, is whether President Joe Biden faces the biggest margin call in history.

There is an argument, of course, that Asia is trapped. Any move to reduce its exposure to US debt would almost certainly panic global markets. The turbulence would set Asia back with great ferocity.

Even so, the late-1990s-like risk hanging over Asian markets could intensify. The odds are growing that the team led by Fed Chairman Powell will continue to hike rates in the months ahead.

As this Western tightening shakes up the year in Asia, China is doing more than its share to generate headwinds closer to home. The Covid-Zero strategy that Chinese leader Xi Jinping can’t seem to let go of has already pushed growth in Asia’s biggest economy to a 30-year low.

There are now new concerns that the third term Xi just won could be tough on China’s gross domestic product. Xi surrounds himself with loyalists who may prioritize security over economic growth and structural reforms.

Asian central banks are also generally moving away from the excessive stimulus measures of recent years. This likely means additional headwinds from the East. This is especially true as inflation rates rise from the United States to Seoul.

The Fed, meanwhile, is heading for another 75 basis point tightening move next week. Economists will also be looking closely at how Fed officials explain their actions and any hints they might drop about where things are headed.

“Their language on this issue will be very important, with any softening in their tone likely to boost stocks and bonds and hurt the dollar or more hawkish language having the opposite effects,” said strategist David Kelly of JPMorgan Asset Management.

Overall, according to ING Bank economist Padraic Garvey, there are few convincing signs that US activity is slowing to deter the Fed. “This latest compelling move back above 4% for the US 10-year is further confirmation that the low rate environment is far behind us,” Garvey said. “It seems the only way is higher market rates.”

All of this leaves Japan in bad shape. The nearly 30% drop in the yen this year is a mini-crisis for Tokyo. As the Fed hikes rates, Japan’s decades-long strategy of boosting exports via exchange rates goes awry.

The yen at its lowest level in 32 years has pushed Japan to import runaway inflation faster than the economy can handle. A year ago, Tokyo was struggling with deflationary pressures. Today, consumer prices are rising at an annual rate of 3%.

The risk is that the Bank of Japan acts to boost the yen. If that means big changes in the BOJ’s asset purchases, global markets could shake. It’s one of New York University economist Nouriel Roubini’s biggest worries about the global financial system this year.

A falling Chinese yuan is its own risk. Since Xi secured an outsized third term as leader over the weekend, the yuan has weakened towards 7.3 to the dollar. Along with rising inflation risks in China, a weaker exchange rate increases the chances that real estate developers will default on dollar-denominated debt.

Yen and yuan weakness may be inevitable as US yields head towards 5%. And change everything investors thought they knew about the global economy by 2023.

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