Why the Dollar's Epic Rally May Not Be Over Yet

The U.S. dollar is heading into the new year with strong momentum, and most indicators suggest further gains ahead. Its ascent is closely tied to "U.S. exceptionalism," as the American economy continues to outpace others. Europe remains mired in a manufacturing slump, while China grapples with the fallout of its property market crisis.

‍

Adding to the dollar's allure is the Federal Reserve's cautious approach to cutting interest rates. The enthusiasm surrounding artificial intelligence has bolstered U.S. equities, drawing international investors and enhancing the dollar's appeal. Many also speculate that Donald Trump’s potential return to the presidency could amplify the attractiveness of the U.S. market.

‍

As the year wraps up, the dollar is poised to close its best quarter since 2016 against a basket of currencies tracked by The Wall Street Journal. It has made significant gains against major global currencies and surged particularly against volatile emerging-market currencies. By Monday, the greenback had risen roughly 20% against the Mexican peso and nearly 30% against the Brazilian real over the year.

‍

Analysts predict Trump’s economic policies will be pivotal for the dollar in 2025, with potential implications for inflation and the Federal Reserve's interest rate decisions.

‍

“Where are people investing nowadays? Number one is the U.S.,” remarked Dominic Schnider, head of global foreign exchange at UBS Wealth Management.

‍

However, Schnider and other currency experts are skeptical about the sustainability of the dollar's rally. He believes that investors are overly optimistic about the potential growth spurred by Trump’s proposals to slash taxes and reduce regulations.

‍

Schnider cautions that these expectations overlook risks such as the potential economic backlash from new tariffs on foreign goods. Additionally, the U.S. government’s finances are under strain, with a federal budget deficit exceeding 6% of GDP, compared to 3.1% in 2016 during Trump’s first term.

‍

“What Trump promises seems great for investment and returns. But can we finance it?” Schnider questioned. “That’s where the disappointment happens.”

‍

He forecasts that the dollar may lose steam as early as the first quarter, potentially ending 2025 about 5% lower against the euro and 8% weaker against the Japanese yen.

‍

The dollar’s prolonged rise over the past decade has defied many experts, who argue that it is significantly overvalued relative to historical levels and faces growing U.S. budget and trade deficits. According to Bank of America, the dollar is estimated to be over 20% above its "fair value" based on trade and interest-rate differentials.

‍

While momentum can drive the dollar above fair-value estimates for extended periods, history suggests that corrections eventually follow. For instance, the dollar climbed sharply in the 1990s, peaked after the 9/11 attacks, and then declined through much of the 2000s, hitting a low during the global financial crisis in 2008.

‍

Hugh Gimber, global market strategist at J.P. Morgan Asset Management, pointed out that the dollar is already at elevated levels, which could make additional gains challenging. “Investors must consider how much ‘U.S. exceptionalism’ is already reflected in market prices,” he said. “The dollar is much stronger today than it was ahead of President Trump’s first term in 2016.”

‍

Athanasios Vamvakidis, head of G-10 foreign-exchange strategy at Bank of America, believes tariffs and the Fed’s restrained approach to rate cuts could provide a short-term boost to the dollar early in the year. However, he anticipates a decline later, regardless of whether Trump fully implements his policy agenda.

‍

If Trump successfully enacts his proposed tariffs, tax cuts, and immigration reforms, inflation could rise more than markets expect. While this might initially strengthen the dollar by prompting the Fed to halt or even reverse rate cuts, it could eventually slow the economy and weigh on the currency. On the other hand, if Trump’s policies are diluted, their growth-boosting impact could diminish, causing U.S. economic outperformance to wane.

‍

Investors often look to Trump’s first term for guidance. After his 2016 election, the dollar surged but peaked before his inauguration, then fell 7.5% in 2017, marking its worst year since 2007 for the WSJ Dollar Index.

‍

“The market has tried to price, in a month, the next four years, and Trump has not even started yet,” Vamvakidis observed. “The lesson from his first term was that it was not a straight line. In some areas, Trump started aggressively, but there were more pragmatic solutions.”

‍

Another factor to watch is the potential recovery of foreign economies, which have been overshadowed by the U.S. surge. The euro has been under pressure as Europe flirts with recession and political instability looms over its largest economies.

‍

Steve Englander, head of G-10 foreign-exchange research at Standard Chartered, suggests that even modest improvements in Europe’s economic outlook could lift the euro. “When was the last time anybody said anything good about Europe? Europe looks weak, but that’s well-known,” he said. “For the euro to go up, all you need is for people to be moderately positively surprised by anything.”

‍

While the dollar’s position remains strong, a mix of global recovery, policy risks, and overvaluation could eventually bring its rally to a halt.

‍