The U.S. dollar has declined by about 4% since July against a basket of currencies including the euro, British pound and Canadian dollar and is now hovering near the low end of a broad trading range that has prevailed since late 2022. Over those past two years, every time the U.S. dollar index has dropped to this current level, it was due to expectations for lower American interest rates. Each time it fell, it rebounded.

Now, with the Federal Reserve embarking on what appears to be an extended rate-cutting cycle, the foreign exchange value of the U.S. dollar has the potential to continue falling. However, we don't expect a long-term dollar bear market to develop. The strength of the U.S. economy relative to its major trading partners—such as Mexico, Canada, China and Japan—tends to support the value of the dollar.

The factors pushing the dollar higher relative to other major currencies for much of the past decade remain largely intact. U.S. economic growth has continued to outpace growth in other major countries, and U.S. interest rates are higher than those in the rest of the Group of 10 (G-10) countries.¹ Stronger growth and higher yields on government bonds tend to attract foreign investment and discourage outflows of capital.

However, those differences have narrowed over the past few months as the Fed kicked off its rate-cutting cycle with a larger-than-expected 50-basis-point (0.50%) cut. The yield on the Bloomberg U.S. Aggregate Bond Index has fallen compared to the Bloomberg Global Aggregate Bond Index excluding the U.S. (ex USD). It is now at its narrowest level in two years. In general, higher relative yields tend to make a currency more attractive to hold, as expected returns are higher.

With a yield differential of more than 150 basis points (or 1.5%), holding U.S. dollars is still more attractive than holding lower-yielding currencies, all else being equal, but the advantage has declined. If the Fed were to continue lowering rates at a more aggressive pace than other major central banks, it could weaken the dollar further.

Central banks in most G10 countries are in rate-cutting mode, but the pace has been slower as central banks outside the U.S. deal with a mix of inflation and growth concerns. Moreover, the starting point on yields is lower outside the U.S., giving most foreign central banks less room to cut at a rapid pace. Based on the expected path of the federal funds rate suggested in the Fed's quarterly Summary of Economic Projections released in September, yield differences appear likely to tighten further, weighing on the dollar in the near term. However, the bulk of the narrowing in differentials has probably already occurred.

The Bank of Japan is the only major G-10 central bank that is raising interest rates. After decades at zero, the central bank has raised short-term interest rates modestly and is signaling more hikes ahead. As a major exporter of capital, Japan is a major investor in foreign global bond markets. At less than 1%, its 10-year bond yields are still low but if rates continue to move up, domestic investors may repatriate capital from abroad. Consequently, the Japanese yen has soared in the past few months, from more than 160 yen to one dollar before Japan's July 2024 rate cut to about 140 yen to one dollar currently. It would not be surprising to see the yen trade back to the 130 level.

Falling oil prices might also be a drag on the dollar. As America is one of the world's major oil producers and exporters, the U.S. dollar has grown more sensitive to changes in oil prices over the last decade. There have been periods of sharp divergence, but the relationship can reflect expectations about growth, inflation, and Federal Reserve policy. Notably, the recent steep drop in crude oil prices has coincided with a drop in the dollar.

In past cycles, emerging market (EM) currencies have tended to appreciate during times when the Federal Reserve was cutting interest rates. The category includes a wide variety of countries with vast differences in growth, inflation, and economic prospects. Consequently, the range of performance has been very wide.

Nonetheless, a Fed easing cycle typically raises prospects for future global growth, which benefits EM countries that rely on exporting goods and services for economic growth. Moreover, many EM countries and companies issue debt in U.S. dollars. When U.S. interest rates decline and the dollar moves lower, the debt is less costly to service.

Since the beginning of July when the Fed began to signal its intention to cut interest rates, many EM country currencies have appreciated sharply, but most are still lower than a year ago.

Assuming that the Fed continues to cut interest rates as projected, and global growth remains relatively firm, then export-oriented EM currencies may continue to appreciate. However, given the wide range of fundamental factors affecting these currencies, there will likely be wide differences in performance.

With the dollar's recent decline, the performance of emerging market bonds as represented by the Bloomberg EM USD Aggregate Total Return Index has exceeded the returns on both the U.S. Agg and the Global Agg ex-US by more than 300 basis points as of September 27, 2024. Year to date, as of October 1, 2024, the total return for the Bloomberg EM USD Aggregate Index is 8.4%, with about half of the increase due to price appreciation and about half due to currency gains.

In the past, periods when the dollar was declining generally helped boost EM bond returns relative to U.S. returns. In the table below, we show periods when the dollar has been dropping by more than 10% and compare the returns of the U.S. Aggregate bond index with the returns of the EM bond index.

If the dollar continues lower due to faster rate cuts from the Fed than other central banks, then international bonds can potentially perform well. However, investors need to be aware that the higher returns come with much higher volatility and risk of default. We typically suggest investors limit allocation to riskier segments of the bond market to temper volatility and potential for losses.

For investors looking for some diversification who are willing to take risk, we suggest accessing international bond markets through a mutual fund or exchange-traded fund (ETF), which offer more diversification than typically available with individual bonds, and may help manage downside risks. The Schwab Mutual Fund OneSource Select List^® and ETF Select List^® can help you identify and research funds that may be right for you.