This week, the dollar strengthened to levels not seen in more than a decade, raising questions about the causes and sustainability of the increase, as well as the consequences for the global economy.
How large is the dollar’s move?
The Bloomberg Dollar Spot Index has gained 3.1 percent since last week. This rally has been broad-based, with the dollar gaining considerable ground against the other major currencies, as well as those of emerging economies.
Is this all caused by U.S. domestic developments?
Much of it is. Over the last week, markets have moved rapidly to price in the prospects for higher growth and inflation after the surprise election of Donald Trump. This has led to a spike in the pricing of future interest rates, both for a December rate hike (market probabilities are now above 90 percent) and for the path of increases after that.
Are there other factors?
Yes. Given that currencies are relative prices, they reflect not just what happens at home but also abroad.
Markets have continued to expect that the European Central Bank and the Bank of Japan will maintain highly stimulative policies, despite the prospects for a less dovish Fed and the fact that both Europe and Japan are set to get growth relief from their weaker currencies. Add to that the impact of higher capital outflows from these countries, as well as from others such as China, that are triggered by growing interest rate differentials and the stronger performance of the U.S. economy.
Politics also plays a role. Trump’s surprise win has led to increased expectations of possible political upheaval in Europe caused by anti-establishment movements, starting with the Dec. 4 constitutional referendum in Italy.
What’s next and what are the consequences?
It’s a mixed picture, especially when it comes to how the dollar will do against the other major currencies compared to its performace against those of emerging markets.
The dollar is likely to continue to strengthen against the euro and the yen, driven by both economic and financial developments, though it probably will be a bumpy ride. The outlook is a lot more ambiguous for emerging-market currencies, given the huge fall they already have experienced against the dollar. Nonetheless, there is scope for them to bounce back over time.
Overall, the recent dollar strength makes easier a global economic rebalancing. Unfortunately, this is occurring at a relatively low level of growth, and after years of frustratingly sluggish and insufficiently inclusive economic expansion. As a result, the dollar’s strength could also set the stage for the return of protectionist rhetoric, especially if the U.S. ends up being the only locomotive of growth in the world economy because of a lack of comprehensive policy responses elsewhere.