We expect the U.S. dollar to grind higher this year, but at a slower pace and with bumps along the way. The chart helps explain what could drive the greenback to further appreciate.

Written by Richard Turnill 

The chart shows that a higher yield differential between U.S. and German government bond yields in the past typically spurred more foreign purchases of U.S. bonds, supporting the dollar. U.S.-led economic reflation, Federal Reserve rate increases and expectations of fiscal stimulus are likely to widen the gap between U.S. and overseas interest rates.

Running on fumes?

Currency trends can be long-lasting. Yet we see a more measured dollar rally ahead, after a nearly four-year run that has already lifted the dollar close to all-time highs on a broad trade-weighted basis.

Various estimates of the dollar’s fair value, based on economic fundamentals, now find it about 15% overvalued. Corporate tax reform proposals in the U.S. could prompt significant expectations for further dollar appreciation, driven by the potential impact on trade and the repatriation of corporate profits held overseas. Yet there is still great uncertainty around the details, timing and potential impact of the incoming Trump administration’s policies.

Bottom line: We see potential for currency volatility ahead, but little risk of a sharp and disruptive dollar rally...