A spike in the Taiwanese dollar reveals the hidden risks of what can happen if US trade policy succeeds

Foreign exchange is often the release valve through which global markets react to shifts in the policy environment.

That’s been on full display over the past few days with the move in the Taiwanese dollar.

The Taiwanese dollar has appreciated by more than 7% relative to the US dollar in the past two sessions, its biggest advance on record. The surge comes amid speculation that the nations’ exporters are converting their dollars back into domestic currency because they are optimistic about the prospects of reaching a trade deal with the US. Given that Taiwan’s currency has been notoriously undervalued for a very long time, in large part because of central bank intervention, the thinking is that any agreement would require some of this artificial weakness in the currency to be addressed. 

But whichever actors started the move, it’s clear which ones will be feeling pressure to react to the sharp appreciation of the Taiwanese dollar. Good news on trade, if it leads to a stronger TWD, is bad news for the Taiwanese financial system.

It goes without saying that when foreign exchange moves, it takes everything with it. From the perspective of global investors, any changes in FX are immediately reflected in what a country’s bonds and stocks are worth in your domestic currency (unless, of course, those holdings are hedged).

For example, from an operating perspective, the 7% appreciation of the Taiwanese dollar shaves 2.8 percentage points off TSMC’s margins, the Taipei-based Central News Agency reported (citing the company).

But it’s the hedging practices of Taiwanese life insurers (or lack thereof) that give this currency appreciation such adverse consequences. 

Taiwan has run massive trade surpluses, which entail a lot of US dollars flowing into the country. The logical end points of a big current account surplus is that either the central bank is building up a lot of foreign exchange reserves and/or private entities are recycling those holdings into foreign assets. The latter dynamic has been dominant for most of the past two decades, particularly for the aforementioned Taiwanese life insurance companies.

These entities have liabilities that are denominated in Taiwanese dollars (payouts to policyholders). But very low interest rates on Taiwanese bonds have meant they don’t really want to invest much in domestic bonds, and a dearth of domestic assets relative to the massive trade surplus meant they couldn’t even if they wanted to. As such, they’ve accumulated a tremendous amount of foreign bond exposure (often US dollar-denominated), a substantial amount of which is unhedged. When the US dollar is tanking relative to the Taiwanese dollar, insurers are staring at steep losses and face pressure to hedge more of that exposure, which can add to the upward pressure on the currency.

Taiwan’s experience is in stark contrast to the typical cause of pain for emerging markets — and Taiwan is still categorized as emerging, per MSCI.

When most emerging markets get into trouble, it’s because they’ve borrowed too many US dollars that they have difficulty paying back, particularly when the greenback is appreciating. That’s the so-called “original sin” of borrowing: when it’s done in a currency that you don’t have the ability to print yourself. (For example, see the 1994 tequila crisis or 1997 Asian currency crisis.)

Why do you need to care about Taiwanese life insurers? Well, the world of finance works in mysterious ways. Crazy enough, the specific investment decisions that Taiwanese life insurers made to reach for yield in the prepandemic cycle contributed to lower US mortgage rates than would have otherwise been the case in the prepandemic cycle, and did the exact opposite when US bond yields were soaring in 2022.

To zoom out: the current moves in Taiwan are at least in part linked to changes in the evolution of trade policy. While several justifications for the administration’s trade policy have been proffered, an overarching motif of President Donald Trump’s thoughts on the subject are that trade deficits are bad. The design of the reciprocal tariff system was based on how large a nation’s trade surplus was with the US. Currencies, obviously, play a role in determining the relative price of an export and the importer’s willingness to purchase it.

The initial “sell America” trade was equivalent to buying a put option on Trump’s trade policy, in part because success in slimming the trade deficit would mean that foreign countries would have fewer US dollars that they needed to recycle back into US dollar assets (including stocks). That was a clear valuation shock.

However, the swift bounce-back in US stocks after reciprocal tariffs were watered down, coupled with hyperscalers’ unwavering commitment to spending billions on chips, meant that the “sell America” trade was also selling a call on AI. If you don’t own US tech giants, you’re effectively passing up all the upside that could be priced into this potentially transformative technology.

The jump in the Taiwanese dollar, which has been echoed at a smaller scale across other Asian currencies, shifts the pendulum back toward the risks of staying invested in US assets (in unhedged terms, at least) rather than the fear of missing out. 

Just as Taiwan’s currency appreciation is a Pyrrhic victory from the perspective of its domestic financial system, so might “success” on trade be negative for US assets.

To this end, it’s “time to reload short USD,” says Brent Donnelly, president of Spectra Markets. His thinking:

“The US equity rally has not generated USD demand. This makes me think that the rally is a short squeeze and it’s not foreign pension funds changing their minds. They continue to add to USD hedges and if they start selling US equities again, the impact should be USD-negative. The dollar trades asymmetrically to equities. Stocks up = USD flat. Stocks down = USD down.”

The timing is ominous: one measure of the US dollar now stands quite close to it multiyear lows. If global markets make another decisive step toward pricing in a regime change for the US dollar, that matters for everyone.