How US dollar strength is impacting Asian bond markets
While “king dollar’‘ has negatively impacted Asian bonds, near-term attitudes do not reflect longer-term value. The current decline may be an ideal entry opportunity.
AS THE US Federal Reserve tightens monetary policy and geopolitical uncertainty stimulates a flight towards safety, the US dollar has surged. In the 12 months leading up to Aug 17, 2022, the US dollar index increased by almost 14.5 per cent. 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.
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Lower relative yields, negative currency returns, 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 2.8 per cent as of 16 August 2022, the yield advantage previously enjoyed by Asian local-currency bonds has noticeably narrowed, 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 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 vs 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 towards 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
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 in favour of why the Asian local-currency bond market may soon see a reversal in its fortunes. Even if such a short-term turnaround fails to materialise, 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.
The writer is Asia-Pacific head of fixed income, State Street Global Advisors.
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