Although yield differential gave the USD a bullish advantage in 1Q 2021, and could do so in the near term, the USD’s experience in 2Q 2021 offered another perspective.
Chief Market Strategist, Asia Pacific
The June Federal Open Market Committee (FOMC) meeting was seen as a key moment in positioning the Federal Reserve (Fed) for a more hawkish policy stance, justified by the strong rebound in U.S. economic activities and surge in inflation. The U.S. dollar (USD) index jumped almost 2% since the meeting and this raises the question of whether the USD could enjoy further support.
A strong argument in support of a bullish USD would be the Fed’s policy normalization and U.S. economic rebound pushing U.S. Treasury (UST) yields higher. The risk to 10-year UST yields in the next three to six months is on the upside towards 1.875-2% and this could indeed be USD-positive. The USD index appreciated by 3.7% in 1Q 2021 when 10-year UST yields jumped 70bps. This reflects partly that the Fed is expected to move ahead of other developed market central banks in policy normalization.
Although yield differential gave the USD a bullish advantage in 1Q 2021, and could do so in the near term, the USD’s experience in 2Q 2021 offered another perspective. UST yields were stable in the quarter and yet the USD index depreciated by 3.9%, cancelling its gain in the first quarter. Interest rate advantage is not the only driver determining exchange rate performance. Market risk appetite, growth differentials and structural factors such as fiscal position and current account balance are also influential.
In terms of growth differential, the U.S. economy is in a bright spot right now. We estimate 2Q 2021 real GDP should grow by 9.8% at an annualized rate, boosted by solid consumer spending. The U.S. economy should continue to grow in coming quarters, but the bright spot could shift to other regions. Europe could be the next region to enjoy a pickup in momentum, as its vaccination progress accelerates. Asia and other emerging markets could also enjoy faster domestic demand recovery in late 2021 and 2022, as a greater proportion of their population is immunized against COVID-19.
Meanwhile, the USD is still facing long term structural headwinds including high fiscal deficit and current account deficit. The International Monetary Fund forecasts U.S. general government gross debt would rise to 133% of GDP in 2021, from 127% in 2020. Its current account deficit is also expected to rise to 3.9% of GDP in 2021, from 3.1% in 2020. Both should stabilize in future years, but improvement is likely to be gradual and limit the upside potential for the USD.
EXHIBIT 1: U.S. DOLLAR AND INTEREST RATE DIFFERENTIAL
In sum, the USD could retain its upward momentum in the near term as UST yields rise, especially against low-yield currencies. However, the sequence of economic recovery in different parts of the world could shift this support for the USD away to other currencies. Structural factors, such as the growing current account deficit and fiscal deficit are also factors limiting upside for the USD.
While the USD strength could be a short-term headwind for emerging markets and Asia, corporate earnings and economic fundamentals should remain supportive. Asian central banks are unlikely to adopt a more hawkish policy stance for now, given the latest outbreaks in the region from the Delta variant are delaying domestic demand recovery. However, for some other emerging market central banks in Latin America and Central & Eastern Europe, the rate hike cycle has already started. This includes Brazil, Hungary, Russia and Turkey. This should help provide some currency stability.