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Dollar Rally Intensifies Amid Diverging US Rate Outlook

The surge in the U.S. dollar is gaining momentum, fueled by persistent inflation concerns casting doubt on the Federal Reserve’s ability to aggressively cut rates compared to its global counterparts.


Year-to-date, the U.S. dollar index, measuring its performance against six major currencies, has climbed by 4.6% and currently hovers near its highest levels since early November. Last week alone, the index recorded a notable 1.7% increase, marking its most substantial weekly gain since September 2022.


This upward trajectory of the greenback reflects growing market consensus that the Federal Reserve will likely maintain interest rates at current levels for an extended period to mitigate the risk of resurgent inflation. The strengthening conviction in this outlook was reinforced by stronger-than-anticipated consumer price data last week, with investors pricing in just 50 basis points of interest rate cuts for 2024, compared to the 150 basis points anticipated at the beginning of the year.


In contrast, expectations have shifted regarding the monetary policy stance of several global central banks, including the European Central Bank, the Bank of Canada, and Sweden’s Riksbank, which are perceived to have greater flexibility in easing policy. This contrasts with earlier beliefs that the Federal Reserve would lead the way in rate cuts.

Eric Leve, chief investment officer at Bailard, remarked, “We had a fairly clear path that the Fed would likely be the first actor. The data that we have received really does undermine that. I can see obvious reasons why the dollar could strengthen further.”

Widening yield differentials between the U.S. and other economies have also contributed to the dollar’s rally, as higher yields enhance the appeal of dollar-denominated assets. Notably, the two-year U.S.-German bond spread reached its widest since 2022 late last week, following indications from the European Central Bank of potential rate cuts as early as June.

Bullish sentiment towards the dollar has surged, while bearish sentiment has waned. Net bets on the dollar in futures markets reached $17.74 billion in the latest week, according to data from the Commodity Futures Trading Commission, marking the highest level since August 2022.

The divergence in central bank policies in recent months reflects the varied challenges faced by economies in containing inflation. While some central banks, such as the Swiss National Bank and Sweden’s central bank, have signaled potential rate cuts, others like Australia, Britain, and Norway have shown less inclination towards monetary easing.

Meanwhile, the Japanese yen has weakened to nearly a 34-year low against the dollar, despite Japan’s recent cessation of eight years of negative interest rates. The Bank of Japan has ruled out using rate hikes to support the currency.

Eric Merlis, managing director and co-head of global markets at Citizens, anticipates a broad appreciation of the dollar driven by a comparatively more hawkish Federal Reserve relative to the ECB. The euro has declined by 3.6% against the greenback this year.

“A stronger dollar could complicate the inflation fight for other economies as it pushes down their currencies, while helping the U.S. tamp down consumer prices by tightening financial conditions,” Merlis noted.

Nevertheless, some analysts remain cautious about the dollar’s potential upside. Shaun Osborne of Scotiabank suggested that the recent strength of the dollar implies that investors have priced in much of the bullish news already. However, favorable rates and spreads suggest continued support for the USD in the near term.