The economic dynamics between the United States and China have become increasingly crucial as the U.Sdollar (USD) continues to rise in value significantlySince the beginning of the year, the dollar index has appreciated by 18%, marking a sharp increase that has reverberated through global currencies, causing many to depreciate against it and reach historical lows not seen in decades.

This prompts critical questions: will the dollar keep soaring amid the Federal Reserve's interest rate hikes? And how will this trend affect the Chinese yuan (CNY)?

Three paths drive the dollar higher through interest rate hikes

The Federal Reserve has increased interest rates six times this year, contributing to the dollar's ongoing rise

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The effects of these hikes on the dollar can be understood through three primary pathways:

Firstly, the asset allocation pathway: as the Fed raises interest rates, it pushes up the yields on dollar-denominated assets, making them more appealingThis shifts the asset allocation of global investors towards dollar assets, thereby bolstering the dollar's exchange rate.

Secondly, there's the market expectation pathway: when interest rate hikes exceed anticipations, they elevate the dollar's valueInvestors react positively, contributing to the dollar's strength.

Finally, the global risk sentiment pathway comes into play; the Fed's tightening measures lead to lowered expectations for economic growth worldwide, causing a flight to safetyCapital flows back to the U.Sduring times of market uncertainty, pushing up the dollar further.

If stronger-than-expected hikes continue, we can anticipate that the dollar will surge even higher.

Moreover, the dollar's surge often begins earlier than the Fed's hikes and concludes sooner as well

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This pattern illustrates how market expectations react in advance of the Fed's decisionsFor instance, short-term U.STreasury yields tend to rise before actual rate hikes; once the Fed begins to lift rates, the hawkish signals it sends to the market keep driving the dollar index upwardsWhen the hikes reach their endgame, we see the 'buy the rumor, sell the news' effect come into play, leading the dollar index to fluctuate at high levelsCombined with other macroeconomic factors, there might even be occurrences where the dollar index starts retreating before the interest rate does.

Faced with high inflation and a strong dollar, consumer demand is currently showing resilience and has not faced significant disruptionHowever, in the long run, the equity multiplier for businesses will be under sustained pressure due to the rate hikes, and high returns driven by solid consumer spending will ultimately lead to squeezed profit margins and lower profit expectations.

Thus, even though third-quarter earnings reports from U.S

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companies showed overall positive performances, there remains a potential downside adjustment for the stock marketFor instance, some foreign investment banks have recently downgraded their growth forecasts for S&P 500 companies into 2024, projecting an 11% decline in earnings per share if the U.Seconomy were to enter a recession.

The Chinese bond market shows signs of improvement

The trend of a strengthening dollar inevitably impacts other currencies tooSince 2008, the British pound has generally depreciated against the dollarA notable event occurred on July 13 of this year when the euro momentarily fell below parity with the dollar, a first since December 2002. Since August, issues like the new tax reduction policy from the UK government and rising inflation expectations have caused the pound to steadily decline

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At one point, the pound-to-dollar rate fell below 1.04, nearly reaching parity.

Looking ahead, the pound still has space to decline, influenced by multiple negative factorsWe believe parity itself does not represent an absolute support levelFirstly, as global economic growth remains sluggish and inflation stays high, central banks are enacting tightening policies while geopolitical risks proliferateThis political and economic landscape does not favor an uptick in the pound's valueSecondly, there is considerable uncertainty regarding the UK and European economies, both of which influence the growth outlook and the stability of the UK government, negatively impacting the pound's exchange rateAdditionally, the British debt crisis has not yet been entirely resolved; any shadow of insolvency concerns could lead to further depreciation of the pound, putting pressure on pound-denominated assets.

The dollar's strength has also led to a swift depreciation of the yuan within a short period, with the USD-CNY exchange rate briefly dipping below 7.3. However, compared to other currencies, the Chinese yuan has shown considerable stability

Since 2022, the yuan has seen considerable two-way fluctuationsYet since the beginning of the year, the CFETS yuan index has remained stabilized around its year-start levels, appreciating against a basket of currencies—3.5% against the euro and 7.8% against the pound over the year.

With China's macroeconomic fundamentals showing signs of stabilization, effective pandemic control measures, and a suite of economic stabilization policies beginning to show their effects, the USD-CNY exchange rate is expected to gradually stabilizeThus, a one-sided depreciation may be hard to achieve.

It is undeniable that China’s economic growth has slowed this year; however, international investors still value long-term opportunities in the Chinese marketIn the bond market, the latest data indicates that as of the end of October, the value of foreign holdings of RMB-denominated bonds stood at approximately 3.4 trillion yuan, down from a historical peak of 4.1 trillion yuan earlier this year