USD to head higher as three factors support the dollar in the near-term – Charles Schwab

Now that the dollar is near the year’s highs, can the rally continue? Economists at Charles Schwab believe it can in the near-term, although their longer-term view is more nuanced.

US interest rates are high relative to global rates

“We compared the 10-year US government bond yield to the average 10-year government bond yield in major developed markets. Barring dollar liquidity crises, the interest rate differential has had a strong relationship with the direction of the dollar – typically rising and falling in tandem. The interest rate differential is currently providing support for a stronger dollar, as it is above 1% and increasing.”

Global central bank policies should support the dollar

“Wth the Fed’s policy rate higher than the currently negative policy rates of the Bank of Japan (BoJ) and the European Central Bank (ECB), support for the dollar should remain intact for the near-term. The bottom line: Once tapering is complete in 2022, as is currently expected, the Fed will have more flexibility to raise short-term rates based on the outlook for inflation and the labor market. By comparison, other major central banks appear likely to maintain easy policies.”

Declining global growth prospects may weigh on EM currencies

“Given that China is a top trading partner of the US, it is the second-highest currency weight in the Fed’s trade-weighted dollar index. This means a weaker CNY translates to a stronger trade-weighted dollar. Lower commodity purchases translate to lower commodity prices, keeping emerging-market currencies down and the US dollar up.”

“Looking out two to five years, we are less positive. The large budget and current account deficits and the prospects for a broader global recovery should put downward pressure on the dollar over the long run.”