In 2022, the US dollar (USD) strengthened nearly 20% off the back of aggressive interest rate hikes from the Federal Reserve (Fed) and safe-haven demand for the dollar amid global uncertainty. But the tide has since shifted, and the USD has come down from those highs. And unlike last year, when the dollar was strong against most currencies (as we laid out in our 2023 Outlook), its moves have now been more nuanced.

So, where is the USD headed in the next few months? And as long-term investors, how should we think about currency exposure? In this month’s CIO Insights, we discuss what drives exchange rates, and what that means for you as an investor with StashAway.

Key takeaways:

• When thinking about currency, remember that there are always two sides to the same coin. For example, apart from the economic conditions in the US, what’s happening in the Eurozone and Japan also have significant impact on the USD, since the currencies of those regions comprise 70% of the US dollar index (which measures it against a basket of foreign currencies).

• Closer to home, medium-term movements for regional currencies in Southeast Asia, like the Singapore dollar (SGD), Malaysian ringgit (MYR) and Thai baht (THB), have been closely correlated with those of key trading partners. Specifically, the Chinese yuan (CNY) has a significant influence on Asian currencies.

• As the Fed gets closer to concluding its rate hiking cycle, we expect currency moves to be more idiosyncratic – meaning that they would be driven more by ‘the other side of the coin’ rather than what’s happening in the US. Specifically, the euro (EUR) may remain stronger and the Japanese yen (JPY) weaker due to differences in central bank policies in those regions. In Southeast Asia, growth challenges in China also point to downward pressure on regional currencies.

Relative differences in bond yields and economic growth have been key medium-term drivers for the USD

Historical data on the relative differences in bond yields and economic growth suggest that those factors have been the main drivers for the USD versus other major currencies. And in particular, these metrics within the Eurozone and Japan are most important to watch as the currencies of these two economies comprise more than 70% of the US dollar index.

First up, bond yields. Higher bond yields in one country can attract more capital flows, leading to increased demand for the currency which contributes to its strength. Periods when US bonds yielded more than those in the Eurozone generally coincided with periods of USD appreciation versus the EUR, and vice versa (graph 2).

Meanwhile in Japan, a long history of lower interest rates relative to the US has contributed to the dollar’s strength. Narrower gaps in interest rates between Japan-US bond yields have coincided with relative dollar weakness (graph 3), and vice versa.

And when a country experiences faster economic growth relative to others, it can attract more investment. This increases demand for its currency and contributes to its appreciation. Here, stronger US growth relative to both the Eurozone (graph 4) and Japan (graph 5) has generally contributed to a stronger dollar versus those currencies over time.

For currencies in Southeast Asia, watch the CNY 

Moving to StashAway’s homebase in Asia, movements in the SGD, MYR, and THB are closely linked to the currencies of their major trading partners. As China is their largest trading partner, that’s meant that the CNY has been a major driver for these currencies over the past few decades. In addition, the MYR has had a significant correlation with the SGD, with Singapore being Malaysia’s second-largest trading partner.

Here’s where we see these currencies headed in the months ahead

Based on the framework we’ve described above, here’s how currency moves are likely to play out over the next few months:

• As we laid out earlier in the year, we continue to anticipate a more nuanced story for the USD compared with last year’s broad-based strength. This is because the Fed’s rate hike cycle is coming to an end, and a resilient labour market will likely lengthen the current stagflationary economic regime identified by ERAA® (we go into more detail in our H2 2023 Market Outlook).

• For the EUR, we believe it will remain stronger versus the USD as core inflation remains stubbornly high in the Eurozone. This means the ECB’s interest rate hiking (and cutting) cycle may lag behind that of the Fed.

• For the JPY, the currency is likely to remain weak against the USD due to both a wide interest rate gap, and relatively easy monetary policy. Here, the trigger for a stronger JPY may only come when the Fed starts to cut interest rates.

• For the SGD, MYR, and THB, we expect these currencies may remain weaker against the dollar over the medium term as subdued growth prospects in China point to a weaker CNY. As of July, Chinese consumption, investment and production data have all undershot expectations – with ongoing pain in the property sector adding downward pressure on the economy. And indeed, deflation, rather than inflation, is the bigger problem for China, with consumer prices down 0.3% year on year.

How does ERAA® consider currency?

An ETF that’s denominated in USD doesn’t mean that the ETF is 100% exposed to USD – its ultimate currency exposure depends on its underlying assets. For example, an ETF that’s listed in the US but tracks Japanese stocks can be fully exposed to movements of the JPY (unless there is a currency hedge included).

As such, even though ERAA® portfolios are quoted in USD, they actually provide exposure to a globally-diversified set of currencies, given the worldwide nature of their underlying assets. ERAA® adjusts the weights to this diversified set of currencies according to regimes. For example, during times of uncertainty, its allocations to safe-haven currencies like the USD and JPY can help to cushion portfolio drawdowns.

This also helps during periods when your home country’s currency depreciates against the USD. Our H1 2023 recap details how our portfolios have managed risk this year.

Ultimately, currency values are always fluctuating – it's just the nature of the market. But if you understand the “hows” and the “whys”, you're better equipped to protect yourself from these fluctuations. The key, as always, is to stay invested in a well-diversified portfolio that builds your long-term wealth.