2025 outlook: The US dollar amid a global easing cycle

Summary

• The global inflation cycle continues to trend lower, underpinning global monetary policy easing. The sharp falls in inflation seen since the pandemic-era peaks have enabled most central banks across the globe to shift gears from prior tightening, though idiosyncratic dynamics have meant a variety of timing differences—some central banks (all among emerging markets) started reducing rates months back, a few have started more recently, and others have yet to cut. An increasing number of countries have seen inflation fall into target ranges, and we broadly expect inflation in the remainder to continue declining toward target, though the path may be a little uneven from here.In tandem with that and noting that most developed markets only started reducing rates fairly recently, we expect this subset of central banks to be reducing rates for some time yet. A notable exception to the global inflation and interest-rate downtrend is Japan, where the Bank of Japan has now begun to normalize policy in response to reflationary conditions.
• We expect US and global growth to have a soft landing. This outlook is underpinned by the interest-rate cycle, and if growth looks like it may undershoot expectations, we would expect central banks to respond appropriately given the supportive inflation backdrop.
• We have for some time now expected the US dollar (USD)—which has moved in a broad sideways range over the past couple of years—to enter a depreciating cycle. We anticipate that both cyclical factors (principally related to interest-rate cycles) and structural factors (particularly the twin current account and budget deficits in the United States) should lead to USD weakness, although we also note that currency paths tend to be uneven. This outlook means that we believe the greatest areas of value in the sovereign bond markets are to be found in non-USD assets, with specific investments selected based on individual country fundamentals. We want to emphasize that we see this as a medium-term trend that is only just starting to materialize—we do not envisage a short-term bounce and retracement.

Cyclical considerations

• Cyclical factors principally refer to interest-rate differentials as well as cyclical growth differentials. There are a number of nuances here, encompassing both what happens in the United States itself and what happens idiosyncratically in various other countries.
• Regarding interest-rate differentials, the United States has lagged many other countries in reducing interest rates. This has helped support the USD until now. However, in September 2024, the US Federal Reserve (Fed) started its interest-rate reduction cycle, kicking off with a 50 basis point (bp) cut that was followed by a 25 bp cut in November, to take the Fed funds rate to a target range of 4.50%-4.75%. We expect the rate-cut cycle to continue through the end of next year. Although the Fed was relatively late in the reduction cycle, most other developed banks started cutting only in the past few months and some have yet to cut. In our view, the Fed easing cycle will be a dominant factor for the USD. The two main comparisons we draw against the Fed cyclically, interest-rate wise, are emerging markets, and Japan.
• Many emerging markets have been early movers in the interest-rate cycles of the past few years, responding quickly to rising inflation in the wake of the pandemic and then consequently being able to lower rates faster when the inflation cycle turned. This means that many emerging markets are at or near the end of their rate downcycles. Indeed, one of the countries that has led this charge—Brazil—has actually now raised rates again (by a total 50 bps) in September and November 2024. Thus, falling US interest rates are likely to see wider rate differentials undermining the USD as these countries have limited scope to cut their own rates further.
• The situation is slightly different for (non-Japan) Asian central banks. Most have been similar to the United States in terms of being relative laggards in raising rates and thus, also have mostly not started to cut rates yet. However, we still expect the interest-rate differential story to support these currencies against the USD; they did not implement aggressive rate rises (due to inflation remaining relatively subdued compared to other regions), with the likely corollary that forthcoming rate reductions will also be relatively restrained. This means that even as both this region and the United States cut rates, here too, the rate differential is expected to widen in such a way as to pressure the USD.
• Broadly speaking, lower interest rates and easier financial conditions improve global liquidity and support fund flows into emerging markets, which is another support for these assets.
• Growth differentials also tend to support assets in countries with relatively higher growth rates. US gross domestic product (GDP) growth has generally surprised to the upside for the past few years, helping to support the USD. However, as US growth is now clearly decelerating, some of that support will be lessened, especially against countries/regions where growth is higher. As the chart below shows, these differentials are mainly in favor of emerging markets.
• We will closely monitor the economic impacts of the policies of the incoming administration in the United States in terms of what is implemented and when. Thus far, the policies proposed by the President-elect (including tariffs, taxes and immigration) would in our view tend to be inflationary and negative for growth, with implications for both short-term and long-term interest rates.

• Japan has been a global outlier for some time as it has faced a few decades of exceptionally low growth and inflation (see also Global Macro Shifts 14). As it emerges from this environment, one of the outcomes is that Japanese reflation is expected to lead to more restrictive monetary policy in the country. The Bank of Japan began removing various monetary accommodation measures earlier this year, including (small) interest-rate hikes in March and July 2024. Japan still has very low interest rates but as they are expected to continue rising (especially when US rates are falling), this should lend the Japanese yen some support against the USD.

Structural considerations

• Structural considerations encompass a range of factors in the United States and beyond, so we will only touch on what we consider the most important here. Particular vulnerabilities in the United States include its structural “twin deficits”—the large current account and fiscal deficits, as well as the associated high government debt level in the United States (estimated at 122% of GDP in 2023). By contrast some countries, in Asia in particular, have persistently strong fundamentals on this basis, encompassing current account surpluses, low fiscal deficits, and low debt levels.

• While we mentioned growth differentials as a cyclical factor, we note also that growth differentials are in part structural. Emerging economies in general tend to grow faster than mature economies. However, we also note that part of Japan’s reflation scenario is a structural improvement in its growth rate. We also highlight that a number of countries across emerging markets, such as India, Malaysia and Mexico—but also including some more mature markets—are likely to benefit from the current reshoring shift in global supply chains, which are expected to add a measure of structural support to growth in those countries.
• Economic reforms are also an important structural factor, which can benefit a number of emerging and frontier markets. Various countries in our investment universe have demonstrated clear evidence of improved policymaking over recent years, with policymakers having taken on board the lessons learned in past crises. Consequently, certain emerging markets have weathered the events of the past few years well, implementing prudent policy to try to protect growth while addressing inflation. Commonly, fiscal reforms have been part of the package, as well as various other macro and balance of payment reforms. International Monetary Fund (IMF) or IMF-led financing has accompanied economic policy reform agreements in a number of these countries, helping these countries to more easily access capital markets.