Since the US presidential election, financial markets have been optimistic about the policy agenda of the incoming Trump administration. The S&P 500 index and the US dollar index rose by 6.6% and 2.5% respectively. The market still seems to believe that US trade tariffs will only cause minor disruptions to the economy, and therefore remains concerned about expectations of strong economic growth. The strength of the US dollar seems to be particularly dependent on this optimistic attitude towards American exceptionalism.

But UBS analysts believe that the market may have underestimated the impact of tariffs, encouraging investors to take advantage of the recent strengthening of the US dollar and prepare for medium-term currency weakness.

Analysts are primarily concerned that financial markets are overly complacent about the negative impact of upcoming changes in trade and immigration policies on US economic growth. The International Monetary Fund estimates that by 2026, US trade tariffs are likely to reduce US GDP growth by half a percentage point. In addition, the adverse effects of immigration restrictions on the labor market will also have a net negative impact on US economic growth.

Analysts point out that investors need to be aware that the implementation of trade tariffs may not be homogeneous, and the impact on different bilateral currency pairs may vary in magnitude and direction.

The euro, pound, and Australian dollar may benefit from the weakness of the US dollar index. Analysts believe that, in addition to the Swiss franc, the erosion of the US dollar interest rate premium will be the main driving force behind the weakening of the US dollar against these three currencies - for more risk averse individuals. The favorable inflation environment in the United States, coupled with loose labor market conditions, should lead the Federal Reserve to cut interest rates by 25 basis points this month and then another 100 basis points in 2025. This will exceed the current pricing, and it is recommended to sell the US dollar to gain profits, which will rebound in the coming quarters.

The gradual decline of USD/JPY is offset by arbitrage costs. It is expected that by the end of 2025, the narrowing of the US dollar interest rate premium will help the USDJPY fall to around 145. The Federal Reserve's interest rate cut may be the main source of this narrowing, and the Bank of Japan will also raise interest rates by 75 basis points by the end of 2025.

However, the arbitrage cost of shorting USDJPY at around 4% per year hinders the sale of the currency pair. Therefore, only when the USDJPY rises to 155 can it hedge against long positions in the US dollar. However, investors based on the Japanese yen are best advised to go long on the Australian dollar or British pound, or sell the upward potential of the Japanese yen against these currencies, in order to achieve a total positive return over the next 12 months.

The pain in the Asian foreign exchange market is uneven. US dollar investors with exposure to Asian currencies (excluding Japan) should hedge against this risk, especially since most of these currencies have lower spreads, making hedging costs low.

Analysts believe that export-oriented economic currencies such as the Korean won, Singapore dollar, Thai baht, and Malaysian ringgit are expected to face pressure. In the context of global trade tensions, currencies of more domestically oriented economies, such as the Indian rupee, Indonesian rupee, and Philippine peso, should be relatively flexible.

However, these economies have current account deficits and rely on offsetting investment portfolio inflows to support their currencies. The blow to global risk appetite will damage these capital flows and may lead to temporary weakness of these three currencies.