Will this currency take over from the dollar?

Thanks to a huge appreciation in the first nine months, 2022 will go down in history as the year of the dollar. While a striking policy change in Japan is now in the spotlight, the currency surprise of 2023 may be closer to home.

2022 was a year full of surprises on currency markets, which will close in style. On Tuesday, Japan's central bank chairman Haruhiko Kuroda announced that the policy rate would remain unchanged at -0,1% and that the range for ten-year government bonds would be widened slightly. The interest on those loans will have room to fluctuate between -0,5% and 0,5% in the future, instead of the current -0,25% and 0,25%. At first glance, this seems like a minor adjustment. But in financial markets it was a shock that reverberated worldwide. It is seen as an advance on a reversal in the extremely accommodative policy of the Bank of Japan (BoJ), which has been pushing long-term interest rates down since 2016.

Bond market disrupted and inflation target met
Kuroda's policy was aimed at fueling Japanese inflation with extremely low interest rates. The adjustment indicates that the limits of this policy have been reached. Due to the purchase policy, the BoJ now has more than half of the total Japanese government debt on its balance sheet. Government bond trading threatens to become disrupted and trading in some tranches has almost completely dried up. Moreover, Kuroda has at least temporarily achieved its objective. Everything points to higher energy and food prices pushing inflation to almost 4% in November. That is child's play given what is happening in Europe and the United States, but in Japan it is the highest level in XNUMX years.

Yen up, global equities down
Many parties took advantage of the extremely low interest rates by borrowing money in Japan and investing it elsewhere in the world at higher returns. If Japanese interest rates rise, this so-called carry trade becomes a lot less lucrative. In that scenario, traders sell their positions to pay off debt in Japan. This explains why a minor policy adjustment by the BoJ caused stock prices to fall around the world, while the yen rose 5% against the dollar. After a share price drop of 30% since the end of 2020, this is an impressive reversal. Whether that turnaround will continue depends entirely on Kuroda's successor, who will soon be nominated by Japanese Prime Minister Fumio Kishida.

Surprise in currency markets
In the meantime, the big surprise on currency markets in 2023 could be a lot closer to home. After an impressive rise, the dollar took a clear step back in the fourth quarter. There are mounting indications that the European Central Bank (ECB) will continue to raise policy rates for longer than the US Federal Reserve. Moreover, so many financial parties have already pre-sorted for a recession in 2023 that the role as a safe haven hardly forms a tailwind for the dollar. If Europe makes it through the winter without a major energy crisis, the euro could easily extend the strong end of 2022 into the new year.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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