Asia FX - The impact of Fed's easing cycle and more

  • Oct 24, 2024

Key Points

With the Fed’s rate cut cycle in place, we look back at three decades of history to distil the implications of the Fed’s easing cycle on Asian FX markets, and more importantly to chart a possible forecast path forward using history. 

Our analysis shows that Fed rate cuts matter, but are certainly not a panacea for Asian FX to strengthen. A simple historical study tells us that Asian currencies only strengthened in 1 out of 5 episodes, 12 months after the Fed’s first rate cut.

Three key factors matter most for Asian currencies based on our study – growth differentials, yield differentials, and risk sentiment. In particular, the Asian Dollar Index has always moved in line with the ‘change in growth differential’ between Asia and the US during the subsequent 12 months’ time post the Fed’s first cut since 1995. Put differently, what matters for Asian FX is not just whether US rates are coming off, but also whether Asian growth is improving relative to the US. Beyond growth differentials, the Dollar’s movement, yield and policy rate differentials between Asia and the US, risk sentiment and whether or not the US enters a hard landing recession also matter greatly for Asian currencies.

Our framework suggests Asian currencies likely have room to strengthen modestly over the next 12 months as the Fed cuts. We are forecasting this not just because US rates are coming lower, but also that we expect US growth to decelerate more relative to Asia, Asian central banks to cut rates but by a smaller magnitude than the Fed, and for risk sentiment to remain decent as the US avoids a hard landing recession. China’s push to implement more stimulus is also an important factor removing left tail risks to Asia’s growth prospects for 2025.

Nonetheless, a material risk to our forecast lies in the US Elections and Trump’s proposed tariffs. Trump’s tariffs of imposing a 60% tariff rate on all imports from China and a 10-20% tariff rate on imports from all other countries if implemented in full, will likely result in weaker Asian currencies relative to our base case, particularly on CNY. In this adverse scenario, CNY would likely depreciate about 9~10% against the Dollar. Using our framework above, these policies imply Asia’s growth will very likely slow more due to weaker export volumes and the negative spillovers from China’s slowdown, and the Fed is also likely to cut at a slower pace at least initially due to stickier inflation.

Historical impact of Fed’s rate cut cycles: FFR cut matters, but not a panacea for Asia FX

Since Fed started targeting the federal funds rate for its monetary policy rate in 1982, six full federal funds rate tightening and easing cycles and an external driven 1998 rate cut cycle have happened. We just entered the eighth Fed’s easing period in September 2024 with a 50bps federal funds rate cut on September 18, after a period of Fed’s steep rate hiking spanning from March 2022 to July 2023 (see Charts 2 and 3).

To understand the impact of Fed’s easing cycle on Asian FXs, in this report, we look back at history with a particular focus on the five easing cycles since 1995 due to the significant structural changes in Asian FX markets prior to that period, including sharp one-off depreciations in the Chinese Renminbi last seen in 1994, and also India’s balance of payments crisis and devaluation of the Indian Rupee in the early 1990s.

Several key observations from these five easing cycles are:

  • In 1 out of 5 cases, Asia currency strengthened against the Dollar, in the 12-month period after Fed’s first rate cut.

There was only one case that Asian currencies strengthened during 12 months after Fed’s 1st rate cut, the case was Fed’s rate cut cycle starting in 1998 due to the Asian Financial Crisis. While in four other episodes, Asia currencies weakened, including Fed’s policy easings starting in 1995 in the Greenspan-led US soft landing, 2001 post the US tech bubble burst, and 2007 before the Global Financial Crisis, and 2019.  We considered the sharp Fed rate cut after the onset of the Covid as part of the Fed’s 2019-2020 easing cycle (see Charts 4 and 5 below).

This observation doesn’t mean that US policy rate cycle is not important in understanding Asia FX movement. It tells us that other factors were at play as well, and they played more dominant roles. For individual easing cycle, often the case is that different key factors were in the driving seat for Asia currency movements. For certain important factors like the US dollar, their performances weren’t always in the same direction during the Fed’s rate cut cycles. This partly explains why bi-lateral exchange rate of Asian currency against the US Dollar often didn’t give a consistent performance across Fed’s easing cycles.  EMEA FX research team has done an analysis from the perspective of the broad Dollar covering the period 1989 to 2019, and has found that the performance of the Dollar is mixed after the 1st rate cut, with a “soft” versus “hard” landing for the US a key differentiator for the Dollar performance post rate cuts (G10 FX Weekly – Muted USD reaction as Fed easing begins).

In each of these cycles, other factors, such as Asia’s economics performances and their relative performance, the global sentiment, geopolitical conditions and many more, worked together driving Asian FXs.

  • 12-month change of relative GDP growth (Asia vs. U.S.) are often consistent with medium-term Asia currency performance.

In every Fed rate cut cycle since 1995, Asian currencies have moved in line with the changes of Asia-US real GDP growth differentials, for the following 12-month period right after the Fed’s first rate cut. Specifically, a positive change in the GDP growth differential between Asia and US in following 12-month after the Fed’s first rate cut has coincided with Asian currency’s strengthening against the US Dollar, and vice-versa (see Chart 6 below).

  • Fed’s rate cut cycle doesn’t necessarily mean a weaker dollar, and the direction of the Dollar matters.

For instance in 2007 before the Global Financial Crisis hit, the Fed started cutting rates first before other central banks due to the slowing US economy as the housing crisis hit. As such, during the first 6-9 months, Asian currencies actually strengthened against the Dollar (see Chart 7 below). It was only until the middle of 2008 when the GFC reverberated meaningfully to the rest of the world and that was when the Dollar strengthened, and Asian currencies weakened materially. Put differently, the Fed rate cut cycle in 2007 started off as a US-centric negative growth shock, which in the first instance supported Asian currencies. This ultimately morphed into a global growth meltdown, weakening Asia’s growth prospects and as such also supporting the Dollar (by triggering the left tail of the US Dollar smile), and leading to weaker Asia FX.

  • The direction of yield spread matters for Asia FX movements

Yield and policy rate differentials between Asia and US also have a good historical relationship with Asian FX (Charts 9 and 10 below). We note that the relationship between rates and FX in Asia and EM more broadly can be complicated by the presence of high-yielding FX (such as INR and IDR), where higher local bond yields are often a reflection of higher perceived sovereign credit risk, rather than stronger growth prospects. This is a key point which we will touch on in the next section.

Relative yield spread signifies the relative return of assets, matters for cross-border flows and pressures on currency to appreciate or depreciate.

  • Status of US economy, soft-landing or recession matters, as it affects risk sentiment

Another notable example to highlight for Asia FX was in 1995 – the classic US “soft landing” episode. This Fed rate cut cycle was the classic example in history of a US “soft landing”, when a Greenspan-led US central bank started somewhat pre-emptive rate cuts from July 1995 for a total of 75bps of rate cuts for that cycle (see Alan Blinder 2023 – Landings, Soft and Hard and also Appendix). During that period, inflation in the US remained around 3 percent for two to three years while unemployment rate trended lower. Also, US stock index went up, reflecting market participants’ appetite for risks.

Having said it, it was also an example that many factors impact on currency movements. Asia’s FX did poorly despite the Fed’s rate cut cycle, a benign situation of global risk on scenario with a soft-landing US economy. It was much poorer Asia’s GDP growth relative to the US (see Chart 8 above) which played a bigger role. Other developed market central banks including the ECB lowered rates relative to US and this also helped to support the broad Dollar, with spillovers to the rest of Asian currencies as well.

Last but not least, the rate cuts starting from July 2019 could be an important example to highlight, given that it was also happening in the background of tariffs by the 1st Trump administration. This Fed rate cut was reasonably short, and of course interrupted by the COVID-19 pandemic starting from March 2020. This cycle was happening as the Fed was trying to normalise policy after seven years with the Fed funds rate at the zero bound, although along the way there were certainly bouts of Fed induced turmoil with the 2013 Taper Tantrum fresh in the minds of Emerging Markets. In part due to the imposition of Trump’s tariffs starting from February 2018, Asia’s growth was already slowing down quite meaningfully during that period, together with a stronger Dollar and weaker Asian currencies. As such, Asian FX was mixed to slightly weaker even though US rate cuts brought some relief at the margin (see Chart1 11 above).

Impact of the ongoing Fed’s easing cycle on Asia FXs

Looking ahead, our base case macro forecasts are for continued Fed rate cuts towards the 3% range into 2025 as the US economy slows down, while for Asia’s growth in general to hold up better than the US with economic drivers such as continued AI chip boom, the implementation of China’s stimulus measures, coupled with decent support from rate cuts and modest fiscal consolidation across Asia. Of course, the outcome of the US elections and possibility of a 2nd Trump Presidency and associated tariffs could become a material risk to our forecasts, with our base case not pricing a large size tariff increase.

1. Our views for Fed policy rates, US and Asia 10-year yield

On Fed policy, MUFG’s US rates strategist George Goncalves continues to see a softer outlook for the US labour market moving forward on the back of high real rates and tighter fiscal policy, notwithstanding the recent bounce in non-farm payroll numbers (see MUFG Rates and Fed Call Update – post NFP induced shock). He is forecasting 2 more 25bps rate cuts by the Fed this year, to end 2024 at 4.375%, with the Fed likely to bring rates closer to the 3% neutral level by 2025. He is also forecasting a steeper US yield curve even as US rates come down over the next 12 months, with US 10-year yields forecasted to end 2025 at 3.75%.

For Asia, we generally think that Asian central banks will cut rates but deliver fewer rate cuts than what the Fed will do. Countries with high real rates such as Indonesia and the Philippines are expected to cut relatively more by around 100-150bps through our forecast horizon. Meanwhile, on the other spectrum, central banks in China and Vietnam are likely to deliver fewer rate cuts in absolute terms but remain dovish in terms of posture given the focus on supporting growth amidst domestic headwinds such as in the real estate sector. Lower short-end rates in Asia will also translate to some extent to declines in Asian 10-year bond yields, and our overall expectation is for Asian longer-end yields to follow US 10-year yields lower, the spread between Asia and US likely edges up next 12 months. The main exception is China where we think a combination of policy measures to support bond yields and fiscal stimulus should push up 10-year CGB yields modestly (see Charts 14 and 15).

2. Our views on “change in GDP growth differentials”

Historical analysis above shows that growth differentials are an important determinant for aggregate performance for Asian currencies post Fed rate cuts.

Looking forward, we expect US growth to slow from an above trend 2.6~2.8% for 2024, to a close to 2% growth for 2025 (IMF forecasts a 2.2% growth for US economy in 2025 and a 2.8% for 2024 in October WEO). Bloomberg consensus forecasts see a 2.6% for 2024 and a 1.8% for 2025.

For Asia, certainly China’s growth prospects will be key not just for itself but also for the rest of the region and the world. We think that recent measures China is taking to push through monetary and in time fiscal stimulus will be important in removing left-tail risks to its growth prospects. We are forecasting China’s growth to slow modestly from 4.8% in 2024 to 4.6% in 2025, and importantly by less than the US.

Beyond China, we generally think that growth will hold up quite well across most Asian countries, with Vietnam, the Philippines and Thailand likely to see a bounce in growth in 2025 as the lagged impact of fiscal and monetary stimulus together with lower inflation boosts growth prospects. In Indonesia, the new government’s focus on both pushing through greater social spending while adhering to its fiscal deficit cap should help maintain foreign investor confidence in the country, and should also help support growth average around 5.1% in 2025. Meanwhile, the export-oriented economies of South Korea and Taiwan are likely to still benefit from the AI chip boom in 2025, even if not at the same growth rate as what we have seen this year.

All-in we think Asia’s growth will slow modestly in aggregate from 4.5% in 2024 to 4.2% in 2025, but by a lesser degree than what we are assuming for the US (2.6% to 1.9%), which should provide some modest support for Asian currencies.

In terms of individual Asian currencies, we think currencies such as KRW, MYR and THB can outperform while the strength of CNY depends on further policy stimulus, in our base case scenario of slower US growth and lower US rates. Beyond our forecasts for the US, for China, we see more efforts will be pushed out and more concrete sizes of the policy support will be announced for the real estate sector and overall economy, this would help strengthen CNY (its current weakness reflects much pessimism) (see ChinaPulse – Expect a modest rebound in both real and nominal growth). For MYR, we expect strong domestic economic growth, current account surplus and resident repatriation of overseas investment proceeds to support the currency. For KRW, Fed’s rate cut could lessen the appeal of US assets and cool Korean residents’ capital outflow, potential inclusion into FTSE WGBI may bring strong foreign bond inflows, while the AI chip boom likely supports exports prospects into 2025. Meanwhile, for THB, the implementation and improvement of fiscal disbursement together with pickup in tourism should help boost Thailand’s growth prospects and also support the local currency (see Chart 20 below and Asia FX Outlook 4Q2024 – Ride with the tide).

3.    Some heterogenous roles may play a part across different Asian economies

It’s important to note that Asia economies are not homogenous and certainly heterogenous factors also matter for individual currency movements.

For example, Asian FX such as INR and IDR are also sensitive to macro stability indicators such as inflation, the level of real policy rates, and current account deficits, among other factors such as growth and yield differentials that we mentioned above. While Fed rate cuts and the associated better risk sentiment are a key transmission mechanism for inflows into these currencies, these macro stability indicators also matter. The collective message in terms of our forecasts is that macro stability looks quite decent for INR and IDR, although we still expect wider current account deficits to lead to underperformance in both INR and PHP relative to other Asian currencies as we look forward into 2025.

Beyond macro stability indicators, some Asian currencies can also be affected by domestic resident outflows. For instance, Vietnam’s local gold price premium with international gold price is often a reflection of domestic outflow pressures. Looking ahead, we generally think that capital outflow pressure including from Vietnam should slow from here.

Risks: Tariff risks from a potential 2nd Trump administration

Asian currencies likely to have further room to strengthen modestly, but watch out for a possible 2nd Trump administration and his proposed tariffs

Overall, our analysis above suggests that Asian currencies likely have further room to strengthen modestly over the next 12 months as the Fed cuts. We are forecasting this not just because US rates are coming lower, but also because we expect US growth to slow more relative to Asia’s, the US to avoid a hard landing recession, and for Asia’s macro stability such as real policy rates and current account to remain sound. Our expectation for China to implement more stimulus and reduce left tail risks to Asia’s growth prospects is also an important factor driving that expectation.

Important and material risks to our views for Asia FX include the US Elections and whether or not that Trump’s proposed tariffs becomes reality. His proposed tariffs of imposing a 60% tariff rate on all imports from China and a 10-20% tariff rate on imports from all other countries, if implemented in full, will likely result in weaker Asian currencies relative to our base case, particularly on CNY. In this adverse scenario, CNY would likely depreciate about 9~10% against the Dollar.

Our framework described above is still useful for thinking about the path forward for Asia FX in that scenario. With Asia’s growth likely slow due to weaker export volumes and the negative spillovers from China, and with the Fed also likely to cut at a slower pace due to stickier inflation assuming full tariff imposition, this will likely imply weaker Asian currencies relative to our base case. Nonetheless, the dispersion of outcomes is meaningful, and depends greatly on the magnitude and comprehensiveness of implemented tariffs (see Global FX Monthly Oct 2024 – Turning to US politics). As a general statement, we think that the likes of CNY and currencies with greater economic linkages with China are more vulnerable in a scenario of full tariff implementation, while INR and PHP should be relatively less vulnerable. To some extent, markets have already been moving to price an increasing probability of a Trump Presidency together with a Republican controlled Congress (see Chart 18 below).

Appendix