US Federal Reserve Chair, Jerome Powell. AFP.
The USD has declined recently and is now close to the lows of mid-2023. EURUSD reached a new 2024 high earlier last month, raising the question of whether the FX market is on the verge of a sustained USD downturn. It is understandable to associate the Federal Reserve (Fed) rate cut cycle with a weaker USD and lower yields, but historical reality is not as straightforward.
During the past six cutting cycles since 1983, the median return of the USD was roughly flat 12 months after the first Fed cut. However, the path of the USD is dependent on the trajectory of economic growth. The USD typically rises by 6% 12 months after the first Fed cut if the US economy achieves a soft landing (3 episodes: 1984, 1995, 2001), but falls by 1% if the economy has a hard landing (3 episodes: 1989, 2007, 2019) (Exhibit 1). This insight on what constitutes a soft landing is adapted from Alan Blinder, “Landings, Soft and Hard: The Federal Reserve, 1965-2022,” Journal of Economic Perspectives, Winter 2023.
Exhibit 1: Fed cuts, USD drops? Historical reality is not as straightforward
Source: Bloomberg, BIS, Bank of Singapore.
In the current cycle, the USD is approaching the expected September Fed rate cut with historically high valuations, largely as a consequence of the USD’s yield advantage over the past two years and superior US asset market returns. Rising Fed easing expectations triggered by the recession scare in early August has fuelled an unwinding of carry trades that benefitted funding currencies like the JPY and CHF. Asian exporters, who had been "hoarding" USD, have also stepped up USD conversion into Asian currencies. US equity markets have been quick to recover from the recession scare. But USD and US bond yields remain slow to do so, as the Fed’s emphasis on avoiding a further weakening of the labour market created asymmetric risk.
Exhibit 2: Markets could now be at risk of expecting too much Fed rate cuts and too little elsewhere
Source: Bloomberg, Bank of Singapore.
The USD is down but not out in our view. Ingredients for a sustained USD fall remain missing if we are right that the US labour market data supports a soft landing. The Fed is likely to take a more gradual easing path than what is now priced. Markets could now be at risk of expecting too much Fed rate cuts and too little elsewhere (Exhibit 2).
It is helpful to remember that FX is a relative game. The non-US side of the FX story matters just as much. It is tough to see the EUR and CNY materially challenging the USD given the Euro area’s stagnation risk and China’s deflation risk. US election risks continues to pose uncertainty to the broad USD and CNY view in 2025. There is also a tariff threat depending on the US election outcome. We anticipate USD gains to be linked to an increasing likelihood of a Trump 2.0 or a Red Sweep scenario.
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