Beware, the dollar could rise further

Despite a rate cut by the Federal Reserve, the dollar has gained significant ground in the week following the American elections. Rising inflation expectations and the way Donald Trump is assembling his cabinet are fueling the fire under the currency.

Also in currency markets, the smoke has cleared after the elections. It quickly became clear that the Republican Party will soon be in charge at the White House, the Senate, and the House of Representatives. This gives Donald Trump all the room to implement his policies without the Democrats being able to apply the brakes. In response, the dollar has risen by almost 3% against the euro within a week. This surge is caused by economists adjusting their expectations for the coming years based on Trump's statements and plans. For the dollar exchange rate, it is particularly important that measures such as import tariffs and tax cuts can fuel inflation.

Included interest rate move
The rising inflation expectation has much more influence on the dollar exchange rate than the interest rate cut implemented by the Federal Reserve last Thursday. The currency world had long since factored in that interest rate move. Traders are now positioning themselves for a policy rate that will not drop as sharply in the future. A few weeks ago, according to the CME Fedwatch data tool, there was a more than 60% chance that the rate in October next year would be at or below 3.5%. That chance has now dropped to less than 7.5%. Instead of a rate cut of over 1.5 percentage points, a decline of at most 1 percentage point is now emerging.

Money flow to the US
In Europe, the German economy is still struggling, so the European Central Bank (ECB) continues on the path of interest rate cuts. In addition to the shifting American interest rate expectations, there are other factors giving the dollar a boost. Economic growth will also be significantly higher next year than, for example, in the eurozone. This leads many European investors to choose to invest their money in the United States, initiating a new flow of funds to the American currency. Some parties are also taking positions in the dollar in anticipation of the uncertainty that arises during a new trade war.

Lighthizer's influence
For example, the Financial Times reported that Robert Lighthizer has already been approached by Trump to shape trade policy. During his previous term, Lighthizer was behind measures such as import tariffs on Chinese goods and services. It is likely that currency markets will closely monitor how Trump shapes his cabinet in the coming months. As traders also prepare for rising inflation, some parties are already considering the scenario where a dollar will be worth as much as a euro in the future. It's still early days, but it could very well turn out that way during Trump's term in office.

Joost Derks

Joost Derks is a currency specialist at iBanFirst with over twenty years of experience in the foreign exchange market. This column reflects his personal opinion and is not intended as professional (investment) advice.

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