Interest rate differentials and other cyclical factors are likely to support a strong USD in the near term. However, as structural factors start to be priced in by markets and considering its current valuation, longer-term risks lean toward a gradual moderation of the USD.
The USD experienced a volatile year in 2024, peaking on robust economic and inflation data in April, then bottoming out as recession fears resurfaced later in September.
Cyclically, U.S. economic growth remains resilient, supported by strong domestic demand. The possibility of policy changes may pose a challenge for the Fed since tariffs can heighten inflationary pressure. With growth expected to slow only modestly, and the risks of “no-landing” reflationary growth re-emerging, the Fed may not cut interest rates as much as the market anticipates. This could support the near-term dynamics of the USD. U.S. growth is likely to remain relatively resilient compared with other DMs, suggesting potential for further capital inflows into the U.S. In short, the USD could remain stable rather than decline.
Meanwhile, factors such as heightened geopolitical tensions could increase demand for safe-haven assets such as the USD or U.S. Treasuries, serving as a defensive allocation in risk-off environments. Additionally, the expanding federal budget deficit could lead to increased U.S. Treasury bond issuance, resulting in persistently high long-term yields. Together, these factors support the view of a stronger USD in the medium term.
Though not part of our base case, there are scenarios where the USD could see a softer run. Domestically, if the U.S. labor market or household balance sheets deteriorate rapidly, leading into a sharper growth slowdown compared with the rest of the world, larger Fed rate cuts could occur, narrowing the interest rate differential with other currencies. Alternatively, if China’s stimulus measures gain momentum, they could bolster its economy and the broader Asian region, supporting a gradual shift into Asian currencies. In addition, as Japan’s positive wage growth and services prices gather momentum, policy normalization will remain a key theme with the Bank of Japan, one of the few central banks to raise interest rates, supporting the Japanese yen.
The balance ultimately depends on the outlook horizon. Interest rate differentials and other cyclical factors are likely to support a strong USD in the near term. However, as structural factors start to be priced in by markets and considering its current valuation, longer-term risks lean toward a gradual moderation of the USD. Investors may consider this an opportunity to rotate into a globally diversified portfolio of equities. Japanese equities’ unique negative correlation to its currency strength also sets it as a worthwhile consideration in portfolios, especially noting its undemanding valuation.
The performance of the USD represented by the trade-weighted USD index and the interest rate differential between the U.S. and a weighted average of major DMs.
Exhibit 3: U.S. dollar and interest rate differential
