Frontier Securities Chief Investment Strategist: The "hard times" for the US dollar seem to be over

After months of steady gains, the US dollar has been giving back its gains in recent months. Over the past year ending in July, the US dollar rose 5% against a basket of currencies before starting to weaken, largely due to increased expectations of a rate cut by the Federal Reserve. The Fed's 50 basis point rate cut in September confirmed this, making the outlook for the US dollar relatively less attractive.

However, the current rate cut expectations are unlikely to be enough to sustain the downward trend of the US dollar, especially after last week's data further confirmed strong US employment.

Ultimately, markets should price based on publicly available information. The current valuation of the US dollar already reflects expectations of a further 150 basis point cut in the federal funds rate from November to the end of 2025. Additional rate cut expectations would require further economic weakness, which is possible but recent strong US employment data suggests otherwise. Boosted by this, the 10-year US Treasury yield has surpassed the key 4% level.

There are broader forces that could support the US dollar. It is important to remember that exchange rate trends largely depend on cross-border trade and capital flows, as well as factors influencing these flows such as fiscal and monetary policies. In short, for the US dollar to weaken, the net capital inflows into the US (i.e., demand for US dollars) must be less than the net selling of US dollars related to trade.

For most of the past decade, the US dollar has benefited from stable capital inflows into US public and private equities and bonds, as well as foreign funds investing directly in the US. Strong economic growth, relatively attractive bond yields, and optimism towards the innovative technology sector could further drive expectations of US stocks outperforming the broader market, enhancing the attractiveness of US dollar-denominated assets.

Currently, some may argue that US assets have been overly favored, making them and the US dollar vulnerable. For example, the S&P 500 index's 12-month forward price-to-earnings ratio has risen to 24 times. FactSet data shows that this figure is significantly higher than the average level of the past 10 years and higher than other major markets.

To continue to pressure the US dollar, attractive overseas market valuations are necessary but not sufficient to keep people away from the US dollar.

History has repeatedly shown that when the US economy and markets perform well, but overseas macro environments are gaining momentum and valuations are relatively more attractive, the US dollar is more likely to weaken in the long term. This combination not only convinces non-US investors to repatriate funds but also encourages US investors to increase their overseas asset allocations.

In recent days, such signs have emerged in China. With China rolling out a package of economic stimulus measures and promising more stimulus, investors immediately bought Chinese stocks and the Renminbi, pushing the Renminbi to its highest level against the US dollar in about 16 months. The question now is whether the government's latest measures are sufficient to boost consumer confidence, drive meaningful and sustainable spending For dollar bears, this is crucial. If growth outside the US, such as in China and Europe, does not continue to improve, the US "soft landing" (even with the support of the Fed's loose policy) may ultimately only attract more capital to US assets, akin to being the "best house in a bad neighborhood".

Of course, the dollar could also strengthen again in the new year, which could be achieved through different channels. If the Fed's loose policy and potential consumer resilience lead to faster economic growth in the US compared to other economies, more funds may flow into dollar assets.

More tricky is if the US election in November leads to a broader, more aggressive trade war, dragging down expectations of growth overseas while causing domestic inflation to rise, prompting the Fed to slow down its easing cycle, the dollar could strengthen.

Lastly, if the world falls into a recession crisis, the dollar could also rise (or at least remain stable). Such an environment often favors the liquidity and safety of the US fixed income market, with related capital flows helping to support the dollar. As 2025 approaches, the worst-case scenario for the dollar may be the best-case scenario for the global economy. However, at present, it is far from certain whether bearish views on the dollar or global optimism will pay off.

This article was written by Rebecca Patterson, former Chief Investment Strategist at Bridgewater Associates