Dollar Rises Ahead of U.S. Jobs Data

The U.S. Dollar Index (DXY) has been on a tear, rising 7% in 2024 despite two Fed rate cuts. The DXY peaked in September 2022 but remains near all-time highs, with the U.S. real broad effective exchange rate (REER) still near record highs. The USD's strength is expected to stabilize or persist into 2025 for several reasons, including economic growth differentials, monetary policy differentials, and potential policy changes under the incoming Trump administration.

Economic growth differentials: The U.S. economy is projected to grow by 2.7% in 2024, outpacing the 1.7% growth forecast for all developed markets. This robust growth, driven by superior productivity growth, higher business investment, and fewer labor supply issues, has contributed to inflation remaining above 2%. This may lead the Fed to halt rate cuts sooner than expected, making a dollar weakening unlikely in the short term.

Monetary policy differentials: The increasing disparity in global growth has led to a greater disparity in central bank policies worldwide. As a result, the gap between U.S. 10-year bond yields and those of its key trading partners has widened to its highest level since 1994. These differentials may remain elevated, as markets are currently pricing in only a limited number of Fed cuts next year (44bps), compared to 110bps for the ECB and rate hikes of 47bps in Japan.

Policy changes: The upcoming administration's focus on boosting domestic manufacturing, increasing tariffs, and deregulating industries could spur business growth and sustain higher interest rates, supporting the dollar. President-elect Trump has also discussed imposing tariffs or other measures on countries that challenge the dollar's trade dominance or reserve currency status.

However, the USD's ascent is unlikely to continue indefinitely. The USD is currently two standard deviations above its 50-year average, suggesting limited room for further appreciation. Historically, the USD has alternated between periods of strength and weakness, making a downturn likely at some point, though the timing is uncertain. Additionally, the U.S.'s persistent trade balance deficit, at 4.2% of GDP as of September 2024, poses a long-term constraint on the currency.

A strong dollar can hurt international company performance for U.S.-based investors, as it makes U.S. exports more expensive and reduces demand for U.S. goods and services abroad. It can also negatively impact U.S. companies with significant international exposure and U.S. exports by making goods more expensive abroad. While a stronger dollar could bolster the 'U.S. exceptionalism' narrative in 2025, investors should carefully assess its potential impact on their portfolios.

In conclusion, the USD's recent strength is driven by economic growth differentials, monetary policy differentials, and potential policy changes under the incoming Trump administration. While the USD's ascent is unlikely to continue indefinitely, its strength can have significant implications for emerging markets, commodity prices, and U.S. multinational corporations with significant international operations. Investors should closely monitor the USD's movements and consider its potential impact on their portfolios.