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The Continuing Surge of the Dollar

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The strength of the U.S. dollar continues to climb, recently reaching its highest level in nearly a year. While this rise can be attributed in large part to higher interest rates in the United States, global investors are also lured by the promise of greater returns.

During its most recent monetary policy meeting, the Federal Reserve kept rates unchanged. However, their rate forecasts suggest that there may be one more 25-basis-point increase this year and a slower pace of cuts compared to previous projections.

Surprisingly, despite these forecasts, markets are pricing in no further increases from the current 5.25%-5.5% fed funds target range as indicated by the CME’s FedWatch tool. Additionally, investors expect an average fed funds rate of 4.8% by December 2024, which is below the Fed’s projection of 5.1%.

This discrepancy between market and Fed predictions underscores the influence of unpredictable economic indicators on monetary policy decisions in the United States, Europe, Japan, and other nations. In fact, there is even a possibility that the European Central Bank may begin cutting rates before the Federal Reserve does.

George Catrambone, head of fixed income for the Americas at asset manager DWS, explains that while it seems logical for the U.S. dollar to continue strengthening, uncertainty surrounding monetary policy clouds the future. He suggests that the Fed may either be finished or have a few more moves left to make.

In the ongoing struggle to reach their 2% inflation targets, both the Fed and the ECB are grappling with their own challenges. Catrambone believes that it may be the Fed that ends up raising rates at least one more time, which would further support the strength of the dollar.

Meanwhile, despite having raised rates by 25 basis points on September 14th, a sluggish economy in the eurozone could mean that the European Central Bank’s rate hikes are coming to an end, while the robust American economy keeps the Federal Reserve less flexible.

In conclusion, while the dollar continues its remarkable rally, the effects of changing monetary policies worldwide make it difficult to determine how much further the greenback can rise.

The Bank of Japan and the Strong Dollar

The Bank of Japan (BoJ) stands out as an outlier among the central banks of developed economies. Unlike its counterparts, the BoJ has kept interest rates around or below zero for the past decade in order to stimulate inflation. This unconventional approach has helped strengthen the US dollar against the Japanese yen.

Recently, however, the BoJ has begun to gradually raise borrowing costs, which has offered some support to the Japanese currency. Nevertheless, the gap between interest rates in Japan and other countries is unlikely to narrow significantly. Currently, the yield on Japanese 10-year government bonds remains close to zero, at 0.8%, while the 10-year US Treasury yield stands at 4.7%.

In comparison, the 10-year German bund yield is at 3%, and its British equivalent is at 4.5%. This interest rate differential has contributed to the US dollar’s strength against both the yen and the euro this year. However, it has weakened slightly against the pound, giving back some previous gains.

Despite predictions of a more favorable economic outlook for the US compared to other advanced economies, investors are increasingly recognizing that persistent inflation is likely to maintain a wide rate differential for several months. Strong indicators in the US provide the Federal Reserve with more leeway to raise rates as necessary to combat inflation, while central banks in Europe, on the other hand, are considering easing monetary policy due to weakening economies.

Edward Moya, senior market analyst at Oanda, highlights that there are sound reasons to believe that the US economy will outperform other major advanced economies. Consequently, he expects the interest rate differential to continue favoring the US dollar.

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