Summary
The return of interest-rate volatility after rate-tightening across developed and emerging economies and associated sharp movements in currencies have reminded many investors of the potential for adding value through foreign exchange (FX).
In this paper we look at three aspects of FX markets, starting with why we believe the dollar’s overall weakness since Q4 2022 extends beyond cyclicality. We review the structural factors pointing to potential longer-term pressure points in the US currency. These include the possibility of the dollar losing its international reserve currency status if the global economy fragments into competing blocs, and the risk of de-dollarization at a time when China is maximizing its efforts to internationalize the renminbi. We also highlight the diversification away from the dollar by central banks and international borrowers.
Second, we outline why we believe the outlook for many emerging markets (EM) currencies looks comparatively positive. Contrary to market wisdom, we think rate cuts by EM central banks that run ahead of the next rate-cutting cycle by the Federal Reserve need not lead to EM FX weakness. In particular, we believe the Brazilian real and Mexican peso look well positioned for a positive outlook, given improvements in the risk profiles of their respective economies and currencies.
Third, we examine the scope for potential alpha-generating currency hedging opportunities that rely less on directional currency views to realize value.
In conclusion, the diverse and idiosyncratic nature of the FX market—whether considering broad-based US dollar perspectives, specific regional and country drivers, or hedging opportunities presented by monetary policy differentials and pricing anomalies—mean it is vital to understand that these disparate markets should not be viewed through a monolithic lens.
Important Information
Published on 27 October 2023.
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