Politics, currencies and relative value

Dollar down

In our note on 16 January we discussed the threats to the US dollar’s value. Since then, it has continued to weaken against a broad basket of currencies and against gold, silver and other commodities. For non-US dollar-based investors in US assets who have not hedged the currency exposure, this has proven very damaging to total returns. In euro terms, US stocks and bonds have underperformed European assets by 2% to 3% (it’s the same case for sterling-based investors). Short-term momentum for the dollar is negative. The Federal Reserve remains on track to deliver more rate cuts this year, and there have been mixed messages from Washington over dollar policy. Of all markets, foreign exchange is one that is very prone to momentum and trend-following strategies, with short-term trading often provoked by technical analysis signals. There will be a lot of capital betting that the dollar weakens through psychologically important levels – $1.20 versus the euro and $1.40 against the pound. 

Multiple drivers

Currency market moves are not easy to analyse. The narrative around the dollar reflects policy uncertainty and shifting geopolitical relations. In practice that suggests investors are rebalancing their portfolios to reduce exposure to the US and US dollar assets. Flows in currency markets come from more than just FX traders putting on speculative positions. There are corporate flows related to trade; portfolio flows related to long-term asset allocation decisions; and possibly flows related to official institutions adjusting their reserve holdings. Fundamental reasons are at play as well – the US has a record net negative international investment position, there are uncertainties about GDP growth while there is more optimism over European and Japanese growth, and the interest rate advantage for the dollar is slowly diminishing. It is also worth remembering that exchange rates tend to overshoot fundamental equilibrium values. The dollar has been in an upward trend for 15 years; its current trade-weighted index level is just 7.4% below its peak level of the last decade (using the Bank for International Settlements index of the narrow US dollar trade-weighted index). 

Yen pivot?

On the other side of the equation is the Japanese yen, which has been very volatile. Against the dollar, the yen has been weakening for the best part of five years. The most recent bout of fragility reflects concerns about debt sustainability in Japan and the sell-off in the government bond market. Economic theory suggests the currency should be strengthening – monetary policy is being tightened, and fiscal policy is set to become expansionary, pushing up bond yields. Japan also runs a massive current account surplus and its foreign exchange reserves have been on the increase again over the last year. Last week there were suggestions that the Bank of Japan would intervene in the markets to prevent any further currency weakness (given concerns that a weak yen would push inflation higher in Japan and put even more upward pressure on local interest rates and bond yields). That remains a threat to putting on bearish yen trades. 

A non-consensual scenario is that the yen strengthens on the back of some repatriation by Japanese overseas investors, and that local yields don’t increase as much as some investors are forecasting. Of course there are policy uncertainties in Japan as well. However, after more than a decade of official intervention in the bond market, yields are finally reflecting medium-term trends in the economy. As I have written about before, long-term government bond yields tend to follow long-term trends in nominal GDP growth. With both inflation and real GDP stronger in Japan, a 10-year bond yield in the 2.25%-2.75% range might well be the fundamental equilibrium range. If so, then in the forward space, Japanese government bonds are entering cheap territory. Hedged into Japanese yen, US dollar or euro yields are lower than equivalent local yields.

US equities still strong which provides some support to the dollar

In the short-term, price action in the currency and bond markets will largely reflect sentiment. The Fed was relatively neutral on the near-term-macroeconomic outlook, arguing for a wait-and-see approach before moving rates again. While geopolitical events might be negative for the dollar, the stock market should be a major support. The fourth quarter earnings season is looking very strong with earnings of those companies that have reported so far growing by 19% on the back of sales growth of 8.9%. There is nothing to suggest the artificial intelligence bubble may burst with solid earnings reports across the broad technology sector.

Note also that given early comments about relative market moves perhaps related to global allocation shifts, US market valuations have fallen a little (market index levels are largely unchanged this year while earnings have outperformed expectations). The 12-month forward price-earnings estimate for the S&P 500 is 2% lower over the last six months (7% for the Nasdaq) while price-to-earnings (P/E) ratios have been increasing for Europe (+5.8% for the Euro Stoxx index) and Japan (+15.5% of the MSCI Japan index). If US macro data surprises to the upside and stock returns, driven by the technology boom, continue to be strong, then a reverse in the dollar’s recent weakness is always possible. The consensus on the dollar seems bearish but there is no appetite for euro strength to continue. A “buy America” trade could be a winning contrarian trade at some point, although if politics are a reason for dollar weakness, a major reversal might not happen before the mid-term elections for Congress in November.

Credit returns – have we seen the best?

Elsewhere the only other comment I would make this week is regarding credit. In both investment grade and high yields, spreads have continued to narrow. The additional yield spread above government bonds, in many markets, is at new lows relative to the period since the global financial crisis. The fundamentals are still supportive for credit, but yields are just above the top of the range of the period between 2010 and 2022 which was dominated by central bank intervention in bond markets. At the start of 2010, the yield on the US corporate bond index was 4.6%; it is 4.8% today. For euro investment grade the comparable yields are 3.7% and 3.10%, and for sterling credit, 5.6% and 5.1%. With spreads narrow and our view that underlying government bond yields are not likely to move much lower, the capital appreciation opportunities in credit are limited. Corporate bonds are still attractive from an income point of view, and credit yields remain above equity dividend yields (at the index level and especially in the US) and cash rates. I would anticipate total returns from credit being lower than the average of the last three years in 2026 but still providing a decent income flow. The caveat to that is yields could move lower in a recession, driven by lower government yields. The only problem is, in that scenario, credit spreads would widen again and on a relative basis, credit would underperform.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, BNP Paribas AM, as of 29 January 2026, unless otherwise stated). Past performance should not be seen as a guide to future returns.