The FINANCIAL -- Overall, the U.S. dollar has rallied this year, with the Dollar Index (DXY) now up by roughly 8 percent year-to-date, according to Bloomberg data. But the gain hasn't been steady. Instead, the dollar has been on a rocky ride, as investors have repeatedly re-calibrated their expectations for U.S. growth and the timing of a Federal Reserve (Fed) rate hike.
Indeed, world currency markets have roared back to life lately after years of hibernation, with a handful of monetary policy surprises-including the European Central Bank (ECB)'s bigger-than-expected bond buying program and the Federal Reserve (Fed)'s delay in raising rates-leading to rising volatility , as the chart below shows. This begs the question: Where will the dollar go from here?
My answer: Though currency market volatility is likely to continue, I still see a stronger dollar over the longer term. Here's why:
Diverging central bank policies
As the U.S. economy continues to modestly strengthen, the Fed will likely begin raising rates later this year, and possibly as early as September. In fact, in her recent testimony before Congress, Fed Chair Janet Yellen laid out a fairly upbeat assessment of the U.S. economy and left the door open for a September rate hike. While the U.S. tightens, most other central banks will likely remain in easing mode. (For more on this monetary policy divergence, check out the BlackRock Investment Institute "Diverging World" interactive graphic ).
The U.S. energy renaissance
As the U.S. has become more energy independent, we've had to import less from overseas. Over the last 10 years, the U.S. current account deficit has been cut roughly in half, and a large part of that improvement has been a function of surging U.S. domestic oil production. Looking forward, rising U.S. production should continue to support a strong dollar.
U.S. dollar rallies have tended to last years, not months
Since the 1970s when the Bretton Woods fixed-currency regime ended and currencies began floating, a typical dollar rally has lasted roughly six to seven years . The increase in the dollar we've seen so far this year is muted compared with the strong dollar episodes of the early 1980s and late 1990s . The dollar's recent rally may just be getting started. In addition, according to the BlackRock Investment Institute , dollar rallies tend to be self-reinforcing-a stronger dollar begets greater inflows into U.S. assets in expectation of further dollar appreciation. For instance, U.S. companies start hedging overseas earnings, increasing demand for dollars.
A rocky ride is par for the course
In past dollar rallies, the dollar's rise is usually not uniform, with lots of dispersion across different currency pairs, and it's characterized by sharp reversals. According to BlackRock Investment Institute research , history suggests the dollar usually rises moderately before the first Fed rate hike, then stumbles for a year (as fixed income markets often take a hit), before resuming its rally. The same pattern could repeat itself this time around.
To be sure, for this cycle in particular predicting currency movements requires divining the behavior of the world's major central banks. The process is further complicated by the fact central bank policy now includes unconventional monetary policies in addition to changes in interest rates.
That said, assuming the dollar continues to appreciate over the longer term, there are several implications for investors. A dollar that remains strong , albeit with some reversals, would put downward pressure on inflation and the earnings of U.S. exporters. Commodities are also likely to struggle in an environment characterized by a stronger dollar and rising real rates.
But further strength in the U.S. dollar would likely be good for equity markets that traditionally outperform on their currency's weakness, such as Japan and the eurozone, as a stronger dollar will make their exports more competitive. Finally, the long-term strength in the dollar boosts the case for considering strategies that can help insulate an international equity portfolio from the impact of weak foreign currencies, such as currency hedged exchanged traded funds (ETFs), according to Nasdaq.