The USD index strengthened by 5.3% to 94.2 since mid-April, meanwhile, emerging market currency saw broad-based weakness vis-a-vis the dollar, esp. those with weaker current account and/or fiscal positions. In this note, we analyze the potential factors contributing to the recent USD strength, and share our thoughts on the forward-looking trajectory of the dollar.

In our view, the recent USD strength has been driven by the following macro events year-to-date:

Growth in Euroland, Japan, China, and some emerging market economies hit a “soft-patch” in 1Q18, while economic and corporate earnings growth have outperformed in the US year-to-date. Granted, part of the set-back in the global manufacturing cycle and headline investment demand growth may be attributable to harsher-than-expected fiscal and monetary tightening in China year-to-date.

Rising Sino-US trade friction and to a lesser extent geo-political uncertainty have triggered a “flight to safety” back to the USD.

In addition, the recent development of the Italian election has also weighed on the euro and the yield curves of the “core” euroland economies.

Will the dollar continue to strengthen? It is worth reiterating that other major economies―e.g. Europe, Japan, and China―are earlier in the reflation cycle than the US, indicating converging monetary policy and a weakening dollar path over the medium term. Meanwhile, the underlying trend of domestic demand remains resilient in both Europe and China.

Furthermore, the yield differentials between US Treasury and bonds in other major economies have already priced in considerable growth divergence, which in our view could be difficult to realize. The yield differential between the 10Y UST and German Bund has already reached 252bp, 2.6 standard deviations higher than historical mean and the highest in three decades.

Our baseline scenario calls for a narrowing gap of growth expectations between the US and the rest of the world, and this is conditional on euroland growth momentum recovering somewhat in 2H18, euroland political uncertainties becoming more benign, and/or cyclical policy “fine-tuning” in China to manage the pace of deleveraging in a more pragmatic manner. Otherwise, a bearish scenario may be sustained USD strength over the short term, which may in turn lead to increased vulnerability of selected EM economies. In our view, stabilized growth and policy expectations in China will go a long way in anchoring the global growth outlook and lowering the “EM risk premium”.