The instinct among global investors looking at this crisis in the Middle East is simple. Oil rises, the Fed delays cuts, the dollar strengthens and everyone adjusts their US exposure accordingly.
What is missing is a very different, and perhaps more dangerous, game dynamic in Japan and Korea.
Both central banks have already raised rates this year to combat energy-fueled inflation. Nor is the surge solving the problem it was meant to solve, and the reason matters to anyone holding unhedged Asian currency or fixed-income exposure right now.
The Bank of Japan raised its key rate to 1% in June, the highest level since 1995, citing the shift from crude oil to output prices, which had risen at their fastest pace in more than three years.
Since then, the yen has continued to weaken regardless, slipping past 163 per dollar this week, its lowest level in nearly 40 years, prompting Japan’s finance minister to warn that authorities are prepared to intervene.
A rate hike coinciding with a currency hitting a four-decade low completely breaks the textbook and clearly signals that this is far from a normal tightening cycle.
Korea shows the same dynamic with a sharper edge. The Bank of Korea held its rate at 2.5% for eight consecutive meetings before finally raising it to 2.75% in July, its first hike in more than three years, expressly to protect a weakening profit and curb inflation that is running above 3%.
Consumer prices in June rose at their fastest pace in 21 months, driven largely by conflict-related oil costs. Governor Shin Hyun-song has signaled that more increases are to come.
The problem that no central bank can get ahead of is that when inflation is driven by an external oil shock rather than domestic demand, tightening policy does two things at once. It raises the cost of capital across the economy and does very little to offset the currency’s exposure to the same oil shock that caused inflation in the first place.
Japan and Korea are raising the price of the currency to combat a dollar price problem a world away, in the Strait of Hormuz and off the coast of Saudi Arabia.
This leaves both currencies caught in a squeeze that most global portfolios don’t price into. Rate hikes are supposed to attract income-seeking capital and support a currency. In the case of Japan, this support has not materialized at all and markets may see growth deteriorating beneath the surface. A central bank moving towards weaker growth sends a very different signal than strong growth.
Korea’s export sector, dominated by semiconductors, has held up well enough to hide some of this, but a currency supported largely by chip demand while inflation remains elevated is not the same as true monetary credibility.
Practical exposure for global investors lies in three countries. You are vulnerable and the positions won carry more downside than the simple rate differential suggests because the gains are being driven by cost-push inflation rather than strength.
Japanese and Korean government bonds face a real risk of stagflation, where yields rise on inflation concerns even as growth moderates, a combination that punishes both duration and growth expectations.
And the capital’s exposure to import-heavy Japanese and Korean sectors — utilities, transportation and manufacturers reliant on imported energy — faces margin pressure that the currency’s rise does little to offset.
Contrast this with the position the US Federal Reserve is in. The Fed can simply hold interest rates and wait, because the dollar strengthens on safe-haven demand during Gulf crises almost by default.
Japan and Korea do not have that luxury. They are heading for weakness, not strength, and the market is currently pricing their coins as if the difference doesn’t matter. It does.
A rate hike that fails to support a currency because the underlying growth picture is deteriorating is a warning sign, not a certainty, and it’s exactly the kind of signal that gets lost when investors treat every cycle of central bank tightening as equivalent to the Fed’s.
This also changes the way investors should think about hedging costs. Currency hedges against the yen and earned exposure are typically priced on the assumption that a hiking cycle supports the base currency over time.
This theory is weakened considerably when the growths are a defensive reaction to an external shock rather than a sign of internal strength.
Investors holding Asian fixed-income or currency-unhedged exposure need to ask a very specific question now: Is this rally paying off with currency strength, or is it simply keeping a bad situation from getting worse? In Tokyo and Seoul today, the honest answer seems much closer to the latter.
Global portfolios built around a simple thesis of dollar strength miss a more complex and urgent dynamic position within Asia’s own monetary response to this crisis, where tightening policy and weakening currencies are, for now, occurring simultaneously.
Nigel Green is CEO and founder of the deVere Group
