Text: Zhou Hao, Chief Economist of Guotai Junan International; Zhan Chunli, Analyst of Guotai Junan International
The interest rate differential story will continue this year, and the US dollar is likely to remain high. In the second half of the year, with the continuous deepening of the Fed's interest rate cuts and the possible "paper tiger" effect of Trump's new policy, the volatility of the US dollar may intensify.
The US dollar index has an epic market at the end of 2024, and the main reason behind it is the "re-inflation" logic brought about by Trump's deal. In January 2025, before Trump officially took office as president, the market further strengthened the US dollar index due to Trump's deal and the expectation of US re-inflation, causing the US dollar index to break through 110 points. Subsequently, the US dollar index fell back due to the uncertainty of Trump's tariff policy, and a "roller coaster" market appeared with market news.
Overall, we believe that the US dollar will remain strong in 2025. Specifically, the following three factors have brought about the strength of the US dollar. The first is the expectation of re-inflation. The 10-year US Treasury yield broke through 4.8% in mid-January, then fell back, but remained above 4.5%. The logic behind this is that the market believes that Trump's policies will bring "re-inflation". In this process, the Fed's interest rate cut path will become very uncertain, so the US Treasury yield has risen, pushing the US dollar index to strengthen. The second factor is that due to the slowdown in the Fed's interest rate cuts, the interest rate differential between the US dollar and non-US currencies remains high, and carry trade funds flow to the US dollar, causing the US dollar to strengthen. The third factor is that considering Trump's tariff policy and the impact of the trade war, it may further suppress the growth of non-US economies. Such expectations have lowered the performance of non-US currencies.
In the short term, the US dollar index will surge and fluctuate in the first quarter. But from the perspective of the full-year trend, we believe that the US dollar may rise first and then fall. Entering the second half of the year, with the deepening of the Fed's interest rate cuts and the increase in certainty, the downward pressure on the US dollar exchange rate will be apparent. At the same time, for the performance of the US economy, the market will also have a trading logic of "buy expectations and sell facts", which will also lead to downward pressure on the US dollar.
We believe that in 2025, interest rate differences will still be the key to determining whether the US dollar will remain high. Since the epidemic period, the significant decline in inflation has caused most central banks around the world to shift from previous tightening policies to easing. Due to the different development cycles of various economies, some central banks began to cut interest rates earlier, while others cut interest rates later. However, due to the decline in global inflation levels, inflation in more and more economies has fallen to the target range, which means that more and more central banks are turning to loose monetary policies. In addition to the European Central Bank's continued interest rate cuts in 2025, which is a high probability event, many central banks in Asia, such as South Korea, Thailand, and Indonesia, have just begun their interest rate cut cycle. In contrast, the future path of interest rate cuts in the United States appears to be rugged, which is also reflected in the gradual widening of the interest rate gap between the US dollar and non-US currencies, which has also driven the strengthening of the US dollar. Judging from the interest rate spread between 10-year US Treasury bonds and 1-year Euribor, it has shown an upward trend since the beginning of 2024, reaching 210 basis points in February 2025, while the level at the beginning of 2024 was only 50 basis points.
At the same time, due to the high interest rates of US Treasury bonds, market funds continue to flow into US dollar assets. In the past year, foreign investors' holdings of US Treasury bonds have shown an accelerating trend. As of the end of November 2024, the total amount of US Treasury bonds held by foreign investors reached 8.6 trillion US dollars. From January to November 2024, foreign investors' new US Treasury bonds reached 680 billion US dollars. Although the interest rate difference between the traditional carry currency yen and the US dollar has narrowed, US dollar investment is still the dominant choice in the market because the yen interest rate is still low. Overall, we believe that the interest rate narrative between the US dollar and non-US currencies will continue in 2025.
The fundamentals of the US economy will be another core factor that dominates the trend of the US dollar in 2025. Since the end of last year, US economic data has continued to improve. Coupled with the support of Trump's tax cuts and other policies, the market generally believes that the US economy may show a "no landing" trend. However, in a high-interest environment, there is still great uncertainty about how the US economy will perform. Based on the experience of the past two years, in the fourth quarter of 2023, when the 10-year U.S. Treasury bond interest rate approached 5%, the U.S. economy experienced a significant decline, and ultimately led to a sharp increase in the market's expectations for a rate cut in 2024 at the end of 2023; another case is that in April 2024, when the 10-year U.S. Treasury bond interest rate rose sharply again, the U.S. stock market showed significant weakness. In terms of these two scenarios, high interest rates also mean an Achilles heel for the U.S. economy. Although relatively high interest rates are supported by good economic performance, excessively high interest rates will have a negative impact on the macroeconomy and capital markets. The market is certainly easy to accept the "Goldilocks" effect from the economic level at the beginning, but it is also necessary to pay attention to the "black swan" from the interest rate side. In general, trees will not grow to the sky, and the U.S. economy will not undergo drastic changes in the short term due to changes in presidential policies.
Therefore, we tend to believe that the support from Trump's policies will gradually lead to aesthetic fatigue as Trump takes office. From this perspective, we believe that the first quarter of this year will be the high point of this round of the US dollar index. After Trump's policies are implemented, the US dollar will weaken because the boots have landed. On the other hand, the market's overheated expectations for the US economy will also cool down due to normal economic fluctuations and the suppression of high interest rates, which will also lead to a decline in the popularity of the US dollar.
For emerging market currencies, the first quarter of this year will still face the pressure of depreciation and capital outflow, but from historical experience, most emerging economies have experienced multiple rounds of similar shocks and have accumulated considerable experience in dealing with them. Similarly, exchange rate depreciation will also bring support for exports, which also means that the economy will show its own dynamic adjustment. Therefore, concerns about a strong dollar should not be exaggerated.
In summary, we believe that in the short term, the US dollar index will have enough motivation to remain strong under the logic of Trump trading, carry trading and continued strength of the US economy. Throughout 2025, the story of interest rate differences will continue, which makes it highly likely that the US dollar will remain high. However, as we enter the second half of the year, the Fed continues to cut interest rates, and Trump's new policy may have a "paper tiger" effect, the dollar's volatility may intensify. In the short term, the dollar index is expected to rise above 110, and in the medium term, it will remain at 104-110 points.
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