The US dollar has upset China and Japan

The 10-year bond rate in the US, for instance, is 4.28 per cent and the two-year rate 5.02 per cent. Across the entire yield curve US real interest rates (after inflation) are positive.

In Japan, the same nominal rates are 0.65 per cent and 0.01 per cent respectively. In China, the 10-year rate is about 2.6 per cent and the two-year rate 2.2 per cent. In Australia, the 10-year rate is 4.16 per cent and the two-year 3.85 per cent. In most jurisdictions, other than the US and China, which is experiencing deflation, real interest rates are negative.

It’s not just the rates that are diverging. The US economy has remained quite robust despite the Federal Reserve’s aggressive cycle of rate rises over the past 18 months. Its policy rate has risen from effectively zero to just over 5.3 per cent over that period and may have one more 25 basis point increase to go in this cycle.

Even if the federal funds rate has peaked, it is expected to remain elevated well into next year unless economic growth slows markedly.

Japan, while loosening the cap it has on 10-year bond yields earlier this year, has maintained its yield curve control policy and the ultra-low to negative rates it produced in an effort, unlike most other major economies, to induce sustained (but moderate) inflation and economic growth after decades of economic stagnation.

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China, battling deflation from the severe economic fallout from the collapse in its property sector, high levels of debt and over-capacity in its economy that restrict policy responses and the slowdown in the global economy, might have been expected welcome a weaker exchange rate and the increased export competitiveness – and inflation – that it would generate.

With record outflows of foreign capital – about $US12 billion ($18 billion) last month – the authorities’ focus is more about stabilising the exchange rate and heading off what could develop into a destabilising full-scale capital flight rather than extra income from exports.

The plunge in the rouble relates to a collapse in Russia’s current account surplus, which is running at levels about 85 per cent lower year-to-date than it was over the same period last year.

Lower revenues from sanctioned oil and gas exports and higher import costs related to its military spending on the war in Ukraine, associated social programs and the withdrawal of foreign companies from its economy have been major influences on the currency.

The Australian dollar, trading at its lowest levels against the US dollar in 11 months, is being impacted not only by the interest rate differentials with the US, albeit that they are more modest than most, but also because it appears that the Reserve Bank’s rate cycle has plateaued amidst a slowing economy.

It’s also being influenced by its role as a way for foreign institutional investors to get an exposure to China’s economy that they regard as safer, given the openness of the capital markets and confidence in the legal system, than direct investment in China.

The economic turbulence China is experiencing is affecting, and will continue to affect, the price of the key resource commodities that provide that exposure to China, so China’s woes make Australian dollar assets less attractive to offshore investors.

The combination of the US dollar’s surge and China’s weakness will increase the pressures on other economies, particularly (but not exclusively) those in the Asia-Pacific region, especially those with high levels of sovereign debt and trade deficits.

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Imports will cost more and the cost of servicing and repaying US dollar-denominated debt will blow out even as China, the biggest engine of growth for developing economies in recent decades, slows.

That makes US dollar strength, as the responses from Japan, China, Russia and some of the smaller economies in this region suggest, a destabilising and threatening force and one that will deter central banks from doing what they would normally do when confronted with weakness within their own economies.

Interest rates will have to be maintained at levels higher than warranted by the states of their economies to avoid more significant and disruptive plunges in their currencies and an exodus of foreign capital.

Unless and until US economic growth tapers and expectations of US rates shift towards lower settings, currency turbulence will remain, the dollar will remain a powerful destabilising force for other economies and central bankers and other policymakers will be forced into responses they would prefer they didn’t have to make.

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