Dollar poised for further strength as Fed keeps monetary policy tight

The US dollar, on its longest rally in nearly a decade, appears primed to strengthen further this year as the Federal Reserve is unlikely to loosen monetary policy anytime soon.

The dollar index, which measures it against a basket of six G10 currencies, increased about 0.8% for the week ended Sept. 8, its eighth straight week of gains and the longest streak since 2014.

Inflation, which remains persistently above the Fed’s 2% growth target, and a still-hot labor market have pushed back expectations of interest rate cuts into late 2024 and boosted the likelihood of additional rate hikes this year, bolstering the dollar.

"The recent dollar rally had been primarily driven by the resilience in US activity data, which has in turn forced markets to push back expectations about monetary easing by the Fed," said Francesco Pesole, a foreign exchange strategist with ING. "This will continue to be the driver moving on."

Since mid-July, the dollar has gained on all its G10 peers and the strength of the greenback could continue into early 2024, said Jane Foley, head of FX strategy at Rabobank.

"The market is of the view that Fed rates will remain higher for longer give the resilience of the US economy," Foley said. "In addition, weaker growth in China and in Europe is not good for risk appetite and this should provide more support for the [dollar]."

The US dollar typically rises as interest rates increase because investors move to dollar-denominated investments, including US Treasury bonds. A strong US dollar helps lower the cost of foreign goods while increasing the price of US exports and chilling global demand. A rally in the US dollar in 2022 added pressure to inflation worldwide and increased the costs of foreign debt service.

The dollar will not likely weaken until US economic data stumbles and the growth outlook in China or Europe improves, Foley with Rabobank said.

The Chinese yuan, which has lost about 6% to the dollar since the start of the year, could see a rally if China starts to aggressively defend it. But as the Fed continues to closely watch economic data as the basis of its future monetary policy moves, and inflation and retail sales remain relatively hot, there may be little likelihood of dollar weakness in the near term.

"The dollar may outperform a little while longer here," said Edward Moya, a senior market analyst with OANDA. "The dollar will weaken once the US economic resilient story fades away."