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--Asia Forex Gains 'Increasingly Running On Fumes'
By Stuart Allsopp
     SINGAPORE (MNI) - Asian FX continues to rally despite the continued
narrowing of interest rate spreads between most Asian countries and the U.S. In
total return terms, the Asian dollar index is trading at an all-time high, even
as the average interest rate differentials fall to their lowest levels since
before the Global Financial Crisis. Recent gains are not justified by the
fundamentals, suggesting cautions is warranted, particularly in the event of a
decline in US stocks.
     To assess whether this trend for Asian FX is sustainable, it must first be
determined whether it is being driven by fundamental forces. Emerging market FX
gains can be justified in the face of declining interest rate differentials if
inflation differentials are declining, default risk is declining, or currencies
are recovering from undervalued levels. None of these appear to explain recent
Asian FX gains.
     Looking at differentials, there has been a steady decline in Asian
inflation over the past year while U.S. inflation has risen mildly. But even
with inflation differentials narrowing, real interest rates have still moved in
the U.S.'s favour across the board over the past year as the rise in U.S.
interest rates relative to Asian interest rates has been larger than the rise in
     With real interest rate differentials not explaining Asian FX gains,
another possibility is that declining default risk among Asian currencies has
improved their attractiveness. If we look at Asian-U.S. real interest rate
differentials adjusted for 5-year credit default swaps, the risk-adjusted real
interest rate spread has moved slightly less in the dollar's favour. 
     However, the fall in Asian CDS spreads has been minimal compared to the
much larger move in real interest rate spreads.
     It is also no longer the case that Asian currencies are recovering from
undervalued levels. Most Asian currencies are trading above their long-term
averages in real effective terms, suggesting that they are far from cheap,
having recovered strongly from their late-2016 lows.
     With the fundamentals not explaining recent Asian FX strength, there are
three potential scenarios for the region's currencies. 
     Firstly, weakness ensues in line with the deterioration in risk-adjusted
real yield spreads seen over recent months. 
     Secondly, the fundamental picture moves in favour of Asian FX as the weak
dollar is discounting a surge in US inflation or a policy mistake by the Fed, or
Asian central banks tighten policy significantly. 
     Thirdly, the strength continues regardless of the fundamentals and then
results in a 2008 style snap back.
     Continued Asian FX strength certainly sets up for a potentially painful
reversal, particularly if U.S. stocks begin to decline more sharply. A decline
in US stocks would likely have two negative implications for Asian FX. It would
put upside pressure on US real interest rates as inflation expectations would
likely fall much faster than any decline in borrowing costs as was the case
during the last major Asian FX sell-off during the Global Financial Crisis. 
     Additionally, it would likely create tightness in global credit markets
causing Asian CDS spreads to widen, further undermining risk-adjusted real
yields across the region.
     Global credit spreads have to date taken falling US stocks in their stride,
but if history is any guide sharper declines on Wall Street would be highly
likely to cause U.S. junk bond spreads to widen, triggering similar moves across
emerging market dollar debt. For now, the rally in Asian FX continues, but it is
increasingly running on fumes.
--MNI London Bureau; tel: +44 203-586-2225; email:
--MNI London Bureau; +44 203-586-2226; email:

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