Is Asian FX strength the next driver of USD depreciation?

The dramatic decline in the US dollar this year has become a focal point for investors, raising important questions about its impact on long-term currency valuations. While the recent drop has helped correct some persistent bilateral misalignments, our analysis suggests that the dollar remains significantly overvalued, particularly against many Asian currencies. We believe the next leg of the USD depreciation is likely to be driven by Asian currencies rising towards their fair values.

It is crucial to note that the US dollar’s persistent overvaluation stems from several fundamental drivers. Foremost among these is its status as the world’s leading reserve currency, which has generated continuous demand from global investors and central banks for USD-denominated assets. This “exorbitant privilege” has consistently underpinned the US dollar’s strength. Over the past decade, the combination of solid US GDP growth, impressive equity market returns, and attractive yield differentials has reinforced the narrative of US exceptionalism.

On the other side of the equation, many Asian economies have either actively or structurally undervalued their currencies to support export-driven growth. These countries typically run current account surpluses, which in a free-floating regime would strengthen their currencies. Instead, these surplus dollars have been recycled into US assets, keeping Asian currencies weaker than valuation models would suggest.

Looking ahead, we see compelling reasons to be long Asian FX, as these currencies are likely to drive the next phase of USD depreciation. The convergence of interest rate spreads, expectations of a soft landing for the US economy, and anticipated Federal Reserve rate cuts all point to renewed, cyclically driven US dollar weakness. This should result in falling relative yield differentials, reducing the cost of hedging US investments for investors across Asia.

We have previously highlighted the substantial pool of unhedged US dollar assets across Asia and the associated risks. These risks could trigger a sharp rise in hedging demand, which may, in turn, provide a significant tailwind for Asian currency appreciation. Meanwhile, several policy signals suggest Asian governments may allow or even encourage more currency strength. In Japan, rising inflation and political pressure have increased the likelihood of the Bank of Japan normalising policy further, which would strengthen the yen. The Taiwanese dollar’s rapid appreciation in Q2 and the South Korean won’s rally in early 2025 reflect a growing tolerance for appreciation.

Thus, we believe a concerted rise in Asian currencies is likely in the medium term, resulting in the continued depreciation and unwinding the US dollar’s overvaluation.