On January 13, 2025, the U.S. dollar index surged past the significant threshold of 110, marking its highest level in over two yearsAs the dollar strengthened, currencies such as the euro, Japanese yen, British pound, South Korean won, and Indian rupee plummeted to multi-year lows.

As of January 14, the dollar index remained steady near the 110 mark.

The robust increase in the dollar index was primarily triggered by key non-farm payroll dataAccording to the U.SBureau of Labor Statistics, December 2024 saw an increase of 256,000 in non-farm employment, representing the largest gain in nine months and significantly exceeding expectations of 160,000. Additionally, the unemployment rate unexpectedly fell to 4.1%, below the predicted 4.2%, while average hourly wages rose by 0.3% month-over-month, in line with forecastsFollowing the release of this data, the dollar index continued its climb, easily surpassing the 110 threshold.

Wang Yuxin, a senior researcher at the Bank of China Research Institute, explained to reporters that the ongoing rise in the dollar index is supported by two significant factorsFirstly, the hawkish stance of the Federal Reserve and the policy expectations surrounding the newly elected president have bolstered the dollarThe Fed's aggressive approach keeps returns on dollar-denominated assets high, while potential increases in tariffs proposed by the incoming administration may exacerbate inflationary pressures, further boosting the dollar.

Secondly, the increase in the dollar index reflects changes in several economic indicators in the U.S., such as a stabilizing labor market and robust private consumption, which provide support for the dollarConcurrently, the Bank of Japan continues to delay interest rate hikes and the European Central Bank is engaged in rate cuts, in addition to ongoing global geopolitical tensions, all of which contribute to the dollar's ascendancy.

As the dollar index soared past 110, many are left questioning whether it can continue this upward trajectory

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What subsequent impacts might arise from this monetary storm?

"A Monetary Storm Sweeps the Globe"

As the dollar appreciates sharply, other major currencies have succumbed to multi-year lowsThe euro, which is a primary determinant of the dollar index, fell to 1.0177 against the dollar, its lowest level in over two years and mere points away from parity.

The Federal Reserve's monetary policy being more aggressive than the European Central Bank's has intensified the pressures on the euroPhilip Lane, the chief economist of the European Central Bank, acknowledged that the divergence in monetary policies across the Atlantic has exacerbated the euro's struggles.

If the Eurozone does not continue cutting rates, inflation may dip below the 2% targetLane suggested that borrowing costs should not "remain excessively high for an extended period," as weak economic growth in the Eurozone may lead to significant underperformance in inflation targetsMarkets predict that the European Central Bank may cut rates by 75 to 100 basis points within the year, which would exceed expected cuts from the Fed, leading to continued depreciation of the euro.

The British pound has also demonstrated a troubling trendLu Zhe, chief economist at Dongwu Securities, conveyed concerns regarding the government’s budget proposal, which entails increased taxation and rising fiscal deficitsThis, combined with the recent announcement of a £300 billion bond issuance plan that exceeded expectations, has heightened worries over fiscal sustainability and government debtConsequently, the yields on the UK's 10-year and 30-year government bonds have surged to 4.84% and 5.4%, respectively, levels not seen since the pension crisis of October 2022. Amid these pressures, the pound and British stocks have plummeted, indicating a successful assault on the UK market.

In Wang's analysis, the weakness of non-U.S. currencies, particularly the euro, yen, and pound, has inadvertently provided support for the stronger dollar

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The devaluation of these currencies is influenced by multiple factors, including weakening economic fundamentals and the necessity for expansive fiscal measuresShould the Eurozone's economic growth continue to slow, the euro may face further downward pressureHowever, if surprising interest rate hikes are initiated by the Bank of Japan in their upcoming meeting, the yen could potentially stabilize.

With the dollar index on the rise, numerous nations have rekindled efforts to protect their currenciesFor instance, to defend the Korean won, the National Pension Service of Korea has begun strategic currency hedging, selling dollars in the open market while potentially purchasing up to $50 billion in local currencyThis action comes on the heels of the waning won's performance, which fell past strategic hedging thresholds established by the NPS.

Wang identifies several ramifications that a surging dollar index could have on global marketsFirstly, it heightens the uncertainty surrounding global capital flows, resulting in capital outflows and depreciation pressures on emerging market currenciesSecondly, an appreciating dollar may lead to falling prices for commodities priced in dollarsAdditionally, for businesses and countries reliant on dollar-denominated financing, a stronger dollar would elevate debt burdens and costs.

In the wake of the non-farm payroll numbers triggering a new surge in the dollar index, a crucial inflation test looms ahead.

On January 15, the widely anticipated U.S. inflation report will be releasedGiven the resilience of the labor market and persistent economic performance, market predictions indicate that the year-on-year Consumer Price Index (CPI) for December 2024 might see a slight rebound to 2.8%, while core CPI is expected to hold at 3.3%, significantly above the Fed's 2% inflation target.

Lu forecasts that the CPI in December is likely to continue climbing due to both a low base and persistent inflationary pressures, coming in at around 2.9% by the end of January 2025. He posits that expectations for Fed interest rate cuts are slim, as the interplay between a strong economy and tight monetary policy could dominate January's trading narrative, with potential easing only manifesting with January's non-farm payroll announcement in February.

Moreover, it is vital to observe the correlation between wage inflation and the stickiness of core service inflation

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For example, in November 2024, super-core inflation ticked upwards from 0.31% to 0.34%, while non-residential core services inflation, excluding lodging, fell from 0.30% to 0.19%, marking a decline for two consecutive monthsThe non-farm payroll data showed that the hourly wage growth slowed from 0.4% to 0.3%, raising questions about whether this reduction could drive down non-residential core service inflation, thereby alleviating inflationary stickiness.

What Lies Ahead?

After the dollar index's strong breakthrough past 110, industry experts ponder its trajectoryThere is a divergence of opinions among market players, yet an overarching consensus suggests a relatively strong dollar moving forward.

Javier Corominas, Global Macro Strategy Director at Oxford Economics, noted that divergent macroeconomic conditions support the dollar's strengthThe dollar's real forward yield advantage has strengthened in recent weeks, in line with expectations of a 2.6% GDP growth for the U.S. in 2024, suggesting that the dollar could continue to strengthen for an extended periodAn increase in Treasury yields amid a backdrop of declining global bond beta coefficients will further benefit the dollar as the U.S. economy grows strongerFurthermore, current positioning has not yet reached excessive tightening, implying that flexible forex funds have not aggressively bet against the dollar, indicating that facets supporting dollar appreciation could persist into 2025.

Goldman Sachs strategist Kamakshya Trivedi predicts a roughly 5% rise in the dollar this year, supported by new tariffs coming into effect and ongoing strength in the U.S. economy, although there exists an inherent risk for further dollar strengthThis marks Goldman’s second upward revision of the dollar forecast in approximately two monthsThe robust U.S. growth and perceived inflation risks due to proposed tariffs have led to declining confidence in the Fed's willingness to cut rates anytime soon.

Specifically, Goldman anticipates that the euro will drop below parity against the dollar within the next six months, possibly reaching 0.97 dollars per euro, down from an earlier estimate of 1.05 dollars

The last time the euro traded below parity was in 2022 amid energy crisis concerns due to the outbreak of war, intensifying fears regarding European economic prospectsGoldman also revised its predictions for the pound against the dollar from 1.32 to 1.22, and for the Australian dollar from 0.66 to 0.62 against the dollar.

However, the path forward is fraught with risks.

In the medium term, Lu suggests that the dynamics of financial conditions and economic demand remain influential, with U.STreasury rates potentially reversing trends due to weaker non-farm and CPI data in FebruaryThe January non-farm data, expected to face downward revisions up to 1 million, may significantly adjust perceptionsOver the long term, the president-elect's policy plans signify heightened uncertainty and inflation risks for the U.S. overallThus, the Fed's monetary policy is expected to follow a trajectory that starts weak but strengthens over time, with the possibility of a weak dollar phase from February to May ahead of anticipated rate cuts in March and JuneNevertheless, the latter half of 2025 may witness a temporary pause in such cuts.

Corominas warns that if the Fed opts to proactively loosen policy in response to anticipated economic weaknesses, rather than reactively managing a downturn, the potential for a weakened dollar would increase significantly—a scenario deemed unlikelyWhile the president-elect has threatened increased tariffs on Canada and Mexico, potentially harming those economies more than the U.S., any relaxation of comprehensive tariff policies could also contribute to a weaker dollar.

Looking ahead, Wang assesses that following the dollar index's breakthrough past 110, its growth may gradually diminish, influenced by various factorsParamount among these are the growth outlook and inflationary pressures within the U.S. economy, alongside the Fed's monetary policy stance, which is likely to play a crucial role in determining dollar trends

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