The USD downtrend in the medium to long term should remain intact due to interest rate differential and relative growth performance.
Tai Hui
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In brief
- We expect the USD to weaken in the long term due to valuations, less favorable rate and growth differentials
- A weaker USD allows EM and Asian central banks to be less hawkish, potentially benefitting EM fixed income
- There is also a strong relationship of Asia outperforming developed market in a weak USD environment
Q: Can we expect the U.S. dollar to weaken this year?
The U.S. dollar (USD) is an important influence on asset performance, especially for emerging market (EM) and Asian assets. In 2022, a combination of risk aversion, high inflation and a hawkish Federal Reserve (Fed) has pushed the USD index (a weighted exchange rate index of the USD against a basket of major developed market currencies) to its strongest in almost two decades.
It has since corrected modestly. The USD index is 8.4% lower than the 2022 peak. In the near term, the USD is likely to be driven by U.S. inflation and job data, and in turn, the Fed’s monetary policy path. Yet in the longer run, we expect the USD to remain on a depreciation path, which should benefit both EM/Asia equities and fixed income.
Q: What could drive the USD weaker?
Despite the correction in recent months, the USD is still expensive. The USD index is 11% above its 10-year average and 45% higher than its 2008 low. Another metric of currency valuation is real effective exchange rate, which considers the inflation differences between a currency and its key trade partners. The USD is one of the most overvalued currency with its most recent valuation 1.5 standard deviations away from its 10-year average.
Being expensive is not enough to bring a currency down. One of the triggers for a stronger USD in 2022 was high inflation and the Fed’s hawkish reaction. The increase in policy rates in 2022 was very aggressive by its own history, and also relative to other developed market central banks. This has led to a pick up in government bond yield and this advantage in carry, or interest rate differentials, benefitted the USD.
Now, the Fed is no longer the only hawkish central bank in town. The European Central Bank has also started its policy rate increase in July 2022 and it has also moved aggressively since. Reduced recession risk is adding to ECB’s determination to tackle inflation. There is also speculation that the Bank of Japan could revise its Yield Curve Control policy in reaction to the rise in inflation and the technical distortions to the government bond market reacted from the ultra-loose monetary policy.
In addition to valuation and interest rate differential, relative growth performance could also turn into a disadvantage to the USD. In 2022, the U.S. economy was enjoying the tailwind of recovering from the pandemic, aggressive fiscal stimulus during the outbreak and low borrowing costs. These positive factors could turn into headwinds in 2023. In addition to higher interest rates, fiscal policy is normalizing which reverses the fiscal impulse from stimulus to restraints.
In contrast, euro area’s economic growth performance has been stronger than expected. It avoided the winter fuel shortage, and the job market has been surprisingly resilient. China’s economic momentum is recovering rapidly after relaxing its pandemic restrictions in 4Q 2022, and this positive impulse in economic growth is also benefitting some Asian economies. This reversal and relative growth performance should pressure the USD.
Exhibit 1: APAC ex-JP / DM equity performance and U.S. dollar index
Source: FactSet, MSCI, J.P. Morgan Asset Management. DM = Developed markets. Past performance is not a reliable indicator of current and future results.
Guide to the Markets – Asia. Data reflect most recently available as of 07/03/23.
Investment implications
While the USD could still face some upward short-term pressure in the event of stronger-than-expected inflation print or job numbers, the USD downtrend in the medium to long term should remain intact due to interest rate differential and growth performance no longer offering strong support to the greenback.
EM and Asian assets, both equities and fixed income, should benefit from this development. A weak USD should allow local central banks to devise monetary policy according to local economic and inflation conditions, instead of deploying higher rates just to support their currency. This should help to limit the downside risk to growth due to excessive tightening. Stronger local EM/Asian currencies should also limit imported inflation as well, again allowing central banks to be less hawkish. This should set a positive tone for EM/Asian fixed income.
The expectation of a weaker USD should also attract international capital into EM and Asian markets. The chart above shows that Asia ex-Japan equities outperform DM equities (green line moving higher) when the USD index is weaker (grey line moving higher). As mentioned above, the relative underperformance of the U.S. economy compared with EM/Asia could further reinforce this virtuous cycle for Asian markets with better earnings prospects and supporting Asian equities. This is much needed at a time when Asian export performance is under pressure due to weaker global demand. Yet, we believe more domestic focused companies should show more resilience in their financial performance.
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