The trade-weighted US dollar has gained more than a quarter from the end of 2013 to the start of 2016. So, has the dollar peaked? To answer this question, we need to look at the key drivers of the dollar rally and examine whether their influence can be sustained.
Monetary policy divergence between the Federal Reserve (the Fed), the European Central Bank (ECB) and the Bank of Japan (BoJ) was arguably the most important driver of the dollar rally. The dollar started to gain momentum when the Fed began to taper its quantitative easing program in December 2013, a process that concluded in October 2014. As the US labour market continued to tighten, the Fed began warming the markets to the idea of policy normalisation. Meanwhile, the ECB and the BoJ were actively rolling out aggressive monetary stimulus. The dollar reached a peak after the Fed raised interest rates in December 2015, the first increase in nine years, further widening interest rate differentials between the US and other major economies.
At the start of 2016, financial markets faced a turbulent time due to the unexpected negative interest rate policy by the BoJ, as well as further devaluation of the Chinese yuan. Although the Fed has a domestic mandate of full employment and a 2% inflation target, international developments have become increasingly dominant to its reaction function. After the Brexit vote, the Fed has become even more cautious, citing increased uncertainty over global growth and confidence.
Although most indicators point to robust US activity, pockets of weakness and occasional data disappointment have been enough to unnerve markets and influence expectation with regard to Fed policy. For instance, the US economy expanded by only 1.2% (quarter-on-quarter annualised) in the second quarter of 2016, a pick up from the first quarter but well short of expectations. As a result of this, and also reflecting heightened external uncertainty, futures markets are no longer looking for a Fed funds rate increase in 2016, with the earliest move not expected until September 2017.
For the moment, it seems that the extent of monetary policy divergence the markets had been expecting is unlikely to be realised. As a result, the key catalyst of the dollar’s strength is losing its strength, and it seems probable that the dollar has peaked for the time being. Nonetheless, the US still enjoys the best growth prospects and has the highest government bond yields amongst major economies. Together, these are likely to mean the dollar remains stable and is unlikely to weaken significantly.