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How is Dollar Strength Impacting Asian Bond Markets?

The US dollar has strongly appreciated against most currencies this year. What are the implications for the Asian local-currency bond market?

Asia Pacific Head of Fixed Income, Head of SSGA Singapore

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 Dollar Dilemma

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.

Lower Relative Yields, Negative Currency Returns, and Accelerating Outflows

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?

Short-Term Consensus Does Not Reflect Longer-Term Value

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.

Strong Economic Fundamentals Weighed Against Recession Risks

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.

Is a Comeback for the Bond Market on the Horizon?

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.

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