Dollar likely to strengthen further

The dollar is now the strongest it has been against a basket of seven other major currencies in more than a year. We doubt the rally is over given the relative prospects for monetary policy in the US and elsewhere. Admittedly, the dollar weakened against other major currencies during the initial twelve months of two of the last three major Fed tightening cycles, even though expected short-term interest rates appeared to rise in the US relative to those abroad. But in 1994, the Fed took markets by surprise, prompting a sell-off in US assets that contributed to the dollar’s decline. It is unlikely to do so again. And in 2004, the US current account deficit was nearly 5% of GDP, causing concern that the dollar was fundamentally overvalued and needed to fall. Today the deficit is only around 2% of GDP.