Is the "weak dollar" rebounding or reversing?

Core Viewpoints

We believe that the downward trend of the US dollar has not yet ended. In the coming year, the dollar may still primarily trend downward, but there may be a risk of a rebound in the third quarter (mainly due to the possibility that interest rate cut expectations may not materialize). If a rebound occurs, it may be an opportunity to short again. Against the backdrop of a declining dollar, emerging market equities may perform well.

Summary

The US dollar has continued to weaken this year, dropping 11% in six months.

Before April 9: "American exceptionalism" reverses. Factors such as Trump's tariffs and immigration policies, the Atlanta Fed's significant downward revision of economic forecasts, and weakening employment have greatly increased expectations of a US recession.

Meanwhile, European fiscal expansion has taken shape, and economic expectations have turned optimistic. Germany has passed a fiscal plan worth hundreds of billions of euros. Fundamental data such as the Eurozone manufacturing PMI and industrial output growth rate are also improving. Whether in government policy or economic data, there is a contrast between Europe and the US, leading to a rapid decline in the Germany-US bond yield spread.

After April 9: A decline in demand due to shaken dollar credibility. From mid-April, expectations of a US recession and interest rate cuts began to decrease, US stocks rebounded, but the dollar continued to decline. The unpredictability of Trump's policies, the deterioration of the US fiscal situation, threats to the independence of monetary policy, and Moody's downgrade of the US sovereign credit rating have all diminished the dollar's appeal as a global reserve currency.

What is the outlook for the dollar in the coming year?

We believe that the dollar's decline is not yet over and is expected to continue at least until mid-next year. The recent rise in the dollar is merely a "rebound" rather than a "reversal."

1. The impact of tariffs on the dollar may differ from 2018.

The tariffs in 2018-2019 significantly boosted the dollar, but this time is different: 1) The US is currently at a relatively high interest rate level and is unlikely to raise rates as it did in 2018. 2) The uncertainty of White House policies and US fiscal issues prevent the dollar from acting as a safe haven like in 2018; in the face of trade risk events, the market chooses to hedge with gold. 3) This year, the US has imposed tariffs globally, with higher rates, leading to a more significant decline in US economic expectations compared to Europe, the UK, Japan, Australia, etc.; the "relative advantage" of the US economy has decreased; whereas in 2018, the US mainly imposed tariffs on China, increasing its "relative advantage."

2. Changes in the relative strength of the US and European economies under fiscal expansion.

Both Germany and the US have launched significant fiscal plans this year. According to the average forecasts from five institutions, including CBO and TPC, the "Build Back Better" plan is expected to boost US GDP by 0.1 and 0.6 percentage points in 2025 and 2026, respectively. Germany's fiscal stimulus is expected to boost GDP by 0.7 to 1.0 percentage points in 2026. The appreciation of the euro, the Eurozone's fiscal expansion plans, and the European Central Bank's continued interest rate cuts to stimulate the economy will all boost the nominal GDP growth rate of the Eurozone measured in dollars, suppressing the dollar.

3. Divergence in the pace of interest rate cuts between the US and Europe in 2026. Since the beginning of this year, the European Central Bank has cut interest rates by 100 basis points more than the Federal Reserve. The Federal Reserve has not cut rates this year. From the fourth quarter of this year to the middle of next year, the rate cuts by the Federal Reserve may be significantly greater than those by the European Central Bank. Current market expectations indicate that from September of this year to June of next year, the Federal Reserve will have a total of 3.8 rate cuts, totaling 94 basis points; meanwhile, the European Central Bank is expected to have 1.1 rate cuts, totaling 27 basis points.

4. Trump's "Manufacturing Reshoring" Requires a "Weak Dollar"

From the perspective of capital flows, an expanding current account deficit corresponds to a strengthening dollar, while a declining deficit corresponds to a weakening dollar; from the perspective of export competitiveness, a weaker dollar lowers the price of U.S. goods in the international market. Historically, periods of narrowing U.S. trade deficits often correspond to a "weak dollar."

The Dollar May Rebound in Q3, but the Downtrend Has Not Ended

In summary, we believe that the dollar's downtrend has not yet ended. In the coming year, the dollar is likely to continue its downward trend, but there may be a risk of a rebound in the third quarter (mainly because the expectations for rate cuts in the third quarter may not materialize). If a rebound occurs, it may be an opportunity to short again. Against the backdrop of a declining dollar, emerging market equities may perform well.

Author of this article: Tan Yiming, Source: Tianfeng Research, Original Title: "Tianfeng Fixed Income Tan Yiming: 'Weak Dollar' Rebound or Reversal?"

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