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Can The Dollar Continue To Rally?

Dollar

The U.S. dollar has been a sea of a volatility in recent times as geopolitical risks and lingering trade-war fears continue weighing in. The greenback's performance against a hodgepodge of major world currencies has been a mixed bag, weakening against the euro, British pound, Swiss franc and South African rand, while gaining against the Japanese yen, Canadian dollar, Australian dollar, Russian ruble and Indonesian rupiah in the year-to-date.

Over the past two weeks, the dollar has traded firmly higher against its major rivals, with the ICE U.S. Dollar Index (DXY) climbing nearly 3 percent as trade war tensions gradually dissipated. The currency has also received support from a Fed-friendly inflation number released for the month of March.

ICE U.S. Dollar Index (DXY) Spot Rates

(Click to enlarge)

Source: Bloomberg

Outlook Still Murky

Despite the latest rally, the dollar is far from being out of the woods. Fresh geopolitical concerns regarding possible U.S. airstrikes against Syria have re-emerged as president Trump continues working round-the-clock to rally international support for his cause.

Back home, the latest round of high turnover in Trump's administration looks set to continue, with the president contemplating sending Deputy Attorney General Rod Rosenstein packing his bags. The president's spat with the deputy AG is due to the latter's approval of the FBI's raid on the office of the president's personal lawyer, Michael Cohen.

But geopolitical tensions are just part of what has been holding back the greenback. The mid-and long-term outlook are not too good either, despite expectations to the contrary due to rising rates. Related: What's Behind Today's Cybercrime Explosion?

First off, it's important to dispense with the notion that rising rates mean an automatic rally for the greenback. There really is no iron-clad rule that mandates the dollar has to appreciate every time rates are hiked--historical evidence shows they are just as likely to reverse course, albeit by a smaller margin.

(Click to enlarge)

Source: Oppenheimer Funds

That's the case because exchange rate dynamics are determined by a plethora of factors including capital flows, economic growth differentials between countries, current account deficits, long-term valuations and, of course, interest rates.

The prevailing exchange rate is a reflection of the interplay between all these factors, with both domestic and international factors playing a part in the mix.

Economic growth differentials play a big part in determining exchange rates.

During downturns in the global economy, global risk aversion increases and capital flows favor the U.S. dollar, which is widely viewed as  a safe-haven currency. The reverse also happens when the global economy is on the mend, with the flows reversing and the dollar depreciating. 

Right now, the global economy is probably in the best shape since the financial crisis of 2008. Global asset managers are likely to rebalance their portfolios to reflect this reality, with rest-of-the-world assets benefitting while the dollar loses out.

Related: What Really Drives The Price Of Gold?

Yet another big reason why the dollar is likely to underperform in the long-term is simply because it's coming off multi-year highs. The dollar goes through cheap and expensive cycles that take anywhere from 5-10 years. The currency hit a 15-year high in 2017 and now appears to be on a downtrend.

(Click to enlarge)

Source: Oppenheimer Funds

The chart above suggests that the dollar is about mid-way on the down-leg which potentially implies further weakness for a couple more years.

By Alex Kimani for Safehaven.com

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