I. Federal Reserve Rate Cuts May Not Necessarily Lead to a Weak Dollar

Assuming that the Federal Reserve lowers interest rates in September this year, what would the performance of the US dollar be like in the following three months? Looking at the historical experience of seven interest rate reduction cycles over the past few decades, in fact, out of the past seven rate cuts, only two have led to a weakening of the dollar after three months; three rate cuts resulted in the dollar appreciating after three months, with a significant appreciation trend; and the outcomes of two rate cuts were not significantly appreciating or depreciating, basically showing a flat trend.

Even if we extend the effective period to half a year later, we can still find that the results are roughly the same. Among the seven rate cuts, two resulted in depreciation, two were flat, and three appreciated. Therefore, the relationship between Federal Reserve rate cuts and the trend of the US dollar is not actually certain, and it may even be neutral or slightly bullish.

II. Domestic and International Environments Support the US Dollar Appreciation Channel

Firstly, economic reassessment. The fundamental differences in the economies of the United States, Europe, and Japan are gradually becoming apparent, with the US economy maintaining strong resilience, while the economic fundamentals of Europe and Japan are relatively weaker.

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In terms of the US domestic economy, starting from the demand side, the seasonally adjusted annualized rate of US GDP for the first quarter dropped significantly, from 3.4% in the fourth quarter of last year to 1.6% in the first quarter of this year (preliminary value), leading the market to reduce expectations for the US economy. Looking at domestic and foreign demand separately, it is common to use the sum of resident consumption and business investment to represent the basic domestic demand of the United States; government investment is more policy-oriented and relatively exogenous; net exports represent the foreign demand part, which is also relatively exogenous and tends to fluctuate significantly each quarter. Therefore, by excluding government investment and import and export data and only observing consumption and investment, we find that the growth rate of domestic demand in the first quarter of the United States is 2.3%, which is basically in line with the fourth quarter of last year, so the resilience of the US economy remains prominent. Starting from the supply side, the resilience of the US economy is still relatively strong. Looking at the world's major developed countries, only the labor productivity of the United States has returned to or exceeded the pre-pandemic trend line after the pandemic, while Europe and Japan have not.

Looking at the external environment of the United States, it is also conducive to the US dollar remaining strong. Taking Japan as an example, in recent years, the yen has depreciated significantly, half due to the interest rate hikes by the Federal Reserve, which led to interest rate differentials, and the other half due to a reassessment of Japan's economic fundamentals. The yen exchange rate is closely related to the fundamentals of its digital economy, green economy, artificial intelligence, financial market development, etc. Taking the digital economy as an example, Japan's service trade surplus is showing a downward trend, one reason being that Japan's digital economy has to pay a lot of money to the United States and a portion to China, such as paying for Netflix series, using ChatGPT, and using cloud computing and cloud services, all of which require payments to the United States and a smaller portion to China. Therefore, Japan's current account has also been reassessed, which is related to Japan not keeping up with new technology tracks such as the digital economy and artificial intelligence. In addition, before the pandemic, Japanese residents' financial management was more inclined to invest in domestic assets, but during the pandemic, residents' financial management shifted to online financial management through apps, similar to how we use Alipay, with many young Japanese diversifying their investments into overseas assets. Therefore, while Japanese asset prices seem strong, they are not as strong when the depreciation of the yen is factored out. Even after the Federal Reserve lowers interest rates and the US-Japan interest rate differential narrows, the yen is unlikely to return to its original position, which also means that the US dollar index is unlikely to fall back to its pre-rate hike levels.

Overall, Europe is under the shadow of the Russia-Ukraine war, Japan is in a long-term aging society, lacking the impetus for innovation, while the development of AI in the United States is about to enter a new technological revolution cycle, leading to a reassessment of the economic fundamentals of the world's major economies, and consequently, the reassessment of economic fundamentals brings about a corresponding reassessment of the US dollar index.

Secondly, geopolitical reassessment is also a reassessment track that makes it difficult for the US dollar to weaken even if the Federal Reserve lowers interest rates. The important turning point of geopolitical reassessment was the Russia-Ukraine war in February 2022, after which geopolitical and local conflicts continued, strengthening the attributes of the US dollar as a safe asset and a currency for risk aversion.

Why did the rate cut in 1998 not trigger a depreciation of the US dollar but even led to an appreciation? This is because during the Clinton administration in the 1990s, the United States had a new economic development brought about by the rise of internet technology, which prompted the Federal Reserve to lower interest rates without triggering a depreciation of the US dollar. In this round of rate cuts, the United States not only has an economic reassessment but also a geopolitical reassessment, with a large influx of global funds returning to the United States. Therefore, the combination of economic reassessment and geopolitical reassessment may mean that the strong cycle of the US dollar could last longer than we think.Thirdly, a significant uncertainty for the United States is the upcoming presidential election in the second half of this year. There is suspense between Trump and Biden, and currently, according to polls, Trump seems to be in a more advantageous position. If Trump is elected, in line with his style, he would start his term with a flurry of actions. One expectation is that after Trump's election in 2025, the U.S. economy might experience a brief period of prosperity, including the years 2025 and 2026. However, this prosperity could exacerbate the stickiness of U.S. inflation, prolonging the time for inflation to decline. Therefore, if Trump is elected, the market is expected to react immediately, and the extension of U.S. inflation expectations would further be reflected in asset price valuations. Correspondingly, the process of the Federal Reserve's interest rate cuts might be further extended, thus affecting the U.S. dollar's trajectory. Hence, the factor of the U.S. election could also impact the U.S. dollar.

Overall, the revaluation of the U.S. economy, the relative revaluation of the economic fundamentals of countries corresponding to the U.S. Dollar Index, and the revaluation of geopolitical tensions, coupled with the impact of Trump's election reflected in asset prices, could all provide support for the U.S. dollar.

III. How the U.S. Dollar Strengthening Expectation Affects Global Economic Recovery

Firstly, the impact on the United States itself. The investor structure of the U.S. Treasury bond market has changed. In the past, institutional investors such as commercial banks were the main investors in U.S. Treasury bonds, with their proportion being around 50%-60% before 2023. The advantage of a high proportion of institutional investors is that their holding of U.S. Treasury bonds is relatively stable, less affected by fluctuations in bond prices and yields, thus making the U.S. Treasury bond market more stable. Since 2023, the proportion of investors sensitive to U.S. Treasury bond price fluctuations has risen significantly, increasing by several percentage points, while the proportion of investors insensitive to bond price fluctuations has decreased by several percentage points, thereby intensifying the volatility of the U.S. Treasury bond market.

The U.S. corporate bond market also has potential risks. In the U.S. corporate bonds, the proportion of AAA-rated companies has decreased, while the proportion of junk bond companies has increased. This is difficult to directly judge as good or bad for the bond market; the positive aspect is that it can price junk bonds through the function of price discovery, enhancing financial market liquidity; the negative aspect, from the perspective of financial market stability, is that over the past decade, especially in recent years, the proportion of AAA-rated bonds has significantly decreased, while the proportion of junk bonds has significantly increased. At the same time, when the Federal Reserve significantly cut interest rates in 2020 to save the market, businesses and residents borrowed a large amount of low-interest loans. After the lending cycle, interest rates have not returned to their original low levels, and with interest continuously rolling over, businesses and residents may have to borrow new loans to repay old ones, creating significant economic pressure. Therefore, there are potential concerns in the U.S. Treasury and corporate bond markets, which are also reflected to some extent in the bankruptcy of Silicon Valley Bank at the beginning of 2023 (although Silicon Valley Bank also had its own management mistakes).

Secondly, the impact on the debt of developing countries. The expectation of a strong U.S. dollar has a broad impact on the debt of developing countries, but will it lead to a global systemic risk? It may not, and is more likely to cause localized issues. For example, some heavily indebted poor countries, including Argentina, Brazil, and other Latin American countries, are more dependent on capital inflows and are also sensitive to Federal Reserve interest rate hikes or the U.S. dollar exchange rate. Heavily indebted poor countries might think that although they are heavily in debt, Federal Reserve interest rate hikes or U.S. dollar appreciation will increase the pressure to repay debts, like the "Chaotic Era" in "The Three-Body Problem," these countries might endure and wait, hoping that things will get better by 2024. However, they find that the Federal Reserve did not enter the interest rate reduction cycle as expected in 2024, and perhaps if they endure and wait a bit longer, things might get better by the end of 2024 or the beginning of 2025. What I want to say is that this round of "Chaotic Era" might be longer than we think, and heavily indebted poor countries in developing countries may have underestimated the challenges they will face in the next 1-2 years. This is also a factor that China, as a creditor, needs to consider. Therefore, for heavily indebted poor countries in developing countries, it is essential to recognize the urgency and necessity of this issue and actively seek debt restructuring solutions to address the problem, rather than waiting for the Federal Reserve cycle to pass and solve the problem naturally.

In addition, the impact on China. Although I believe that maintaining a high U.S. dollar and a high China-U.S. interest rate differential should not be a constraint on China's monetary policy, it must be acknowledged that our country's monetary policy will inevitably be restricted to some extent. A high China-U.S. interest rate differential might make our monetary policy, especially interest rate policy, subject to more external influences. Therefore, if monetary policy is affected, domestic fiscal policy must play a more active role, and currently, the crowding-out effect of our country's fiscal policy is relatively small.

However, I personally prefer to believe that our country's monetary policy should not be so much influenced by the Federal Reserve's monetary policy. In addition to interest rate parity, there is also purchasing power parity to support exchange rate stability, and more importantly, there is confidence parity. If our monetary and fiscal policies are relaxed, including other non-economic policies and reform policies, and can truly stimulate the confidence of the private sector and international investors, making everyone feel that the policy is effective, then market confidence will be boosted, which is more important than interest rate differentials and other influencing factors, and decisive. If we regain confidence, the exchange rate will be strongly supported. Therefore, we should release the space for monetary and fiscal policies and make full use of the policy space to exert effort.