The US dollar has strongly appreciated against most currencies this year. What are the implications for the Asian local-currency bond market?
As the US Federal Reserve (Fed) tightens monetary policy and geopolitical uncertainty stimulates a flight toward safety, the US dollar has surged. In the 12 months leading up to 9 June 2022, the US dollar index increased by almost 14%1. No other currency saw that kind of strength. And with the Fed’s tightening cycle just beginning, “king dollar” seems likely to continue its reign.
A robust dollar is undoubtedly positive for US consumers, battered by 40-year high inflation (at least in the short term). For the rest of the world, it has a negative ripple effect that jeopardizes the already precarious post-pandemic economic recovery.
The main reason dollar strength threatens the global economic recovery is that it places many other markets in a dilemma.
If they don’t keep pace with the Fed’s tightening cycle, their currencies will likely depreciate even further against the greenback. This would increase the price of their imports and intensify inflation – a politically unpopular choice. On top of that, most markets have a significant percentage of dollar-denominated debt. Failing to keep pace will heighten the currency mismatch and make their debt payments more expensive.
On the flip side, if they choose to match the Fed’s cadence and tighten monetary policy, they risk doing so prematurely. Most markets have not enjoyed the same level of economic upturn as the US, spurred by massive government and central bank intervention. As such, tightening to keep up with the Fed risks hurting their own economic recovery. Such is the quandary posed by the strengthening US dollar.
Similarly, “king dollar” has negatively impacted the Asian bond market.
In the short term, at least, the strengthening dollar is acting as a drag on Asian bond markets. With 10-year US Treasury yields standing at 3.02% as of 9 June 20222, the yield advantage previously enjoyed by Asian local-currency bonds has noticeably narrowed3 (even though their yields have risen).
Then there is the currency-return aspect to consider. As the dollar strengthens against Asian currencies, the FX-return portion of local bonds falls as well. So, it is no surprise that dollar strength is accelerating the shift away from Asian issuance. In May, Asia ex-Japan bond funds saw their highest outflows of the year4.
In short, market consensus is somewhat downbeat on the prospects for Asian local-currency bonds. Yet, should we always be bound by consensus?
While short-term sentiment surrounding Asian local-currency bonds is negative, this does not necessarily mean that investors should cut their allocations to this asset class. Near-term attitudes do not reflect longer-term value. On the contrary, the facts point toward Asian local-currency bonds still being a worthwhile long-term play, making the current decline an ideal entry opportunity.
There are a few reasons to support this. The first is the dollar strength narrative itself. While the dollar is unlikely to weaken soon, we may see its appreciation plateau. This could mean that future rate hikes may have been “priced in”. Should the dollar’s forward momentum fade, local currencies could stage a comeback, meaning that investors would soon be able to reap a positive return on the currency portion.
The second reason comes down to fundamentals. While it is true that the global economy is facing a slowdown, the underlying health of many Asian markets remains sound. It is important to separate temporary negative factors – such as lockdowns in China – from the deeper financial picture. Of course, careful credit selection remains crucial. Focusing on stable sub-asset classes, particularly government bonds, can mitigate risk.
Finally, as the prospect of recession looms, there is a real possibility for a reversal in the upward yield trajectory that has been happening across the bond market. If US inflation moderates, the Fed may slow its tightening to reduce the risk of a recession. This could pressure yields down across the board, raising bond prices.
There are solid arguments for why the Asian local-currency bond market may soon see a reversal in its fortunes. Even if such a short-term turnaround fails to materialize, this does not detract from its longer-term value. Just as the dollar has retained its position as the world’s reserve currency, Asian local-currency bonds should always have a place in an investor’s portfolio.
All forms of investments carry risks, including the risk of losing all of the invested amount. Such activities may not be suitable for everyone.
Past performance is not a reliable indicator of future performance.
Diversification does not ensure a profit or guarantee against loss.
International Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.
Currency Risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
The views expressed in this article are the views of Kheng-Siang Ng through the period ended 31 May 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
This article is issued by State Street Global Advisors Singapore Limited and has not been reviewed by the Securities and Futures Commission.
This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.