New Year's Eve: The dollar's big year

The US Dollar Index (DXY) ends 2024 up more than seven per cent, beating major developed and emerging-market currencies alike. For the dollar it has been an exceptional year.

The gains were broad. The euro fell as the European Central Bank cut rates four times and Germany's economy stagnated. The yen spent the year near multi-decade lows despite repeated intervention from Tokyo. The Mexican peso slid after June's election in Mexico and again after Donald Trump's victory, and the Brazilian real weakened past 6 per dollar in December amid doubts about Brazil's public finances. South Korea's won fell to its weakest since 2009 after the president's brief declaration of martial law. The index itself is at its highest in about two years.

Growth and rates did it

Two things drove the rally. The American economy grew faster than its peers and corporate earnings held up. Interest-rate gaps also widened, as the Fed scaled back its easing plans while Europe and China struggled. With the incoming administration promising tariffs and fiscal stimulus, the dollar goes into 2025 looking as strong as it has in years.

How rate gaps move money

The mechanism is simple. Investors compare what they can earn on safe assets in different currencies. When American yields rise relative to those in Europe or Japan, money flows into Treasuries and other dollar assets, and buying them requires buying dollars. The ECB's deposit rate now stands at 3 per cent, while the Fed's policy rate is 4.25 to 4.5 per cent, and the gap in long-term bond yields is wider still. The Fed's December signal that it expects only two cuts next year widened the expected gap further, just as other central banks were signalling more easing.

Growth reinforces the effect. Strong American earnings, especially among the technology companies that dominate world stock markets, drew foreign money into American shares. Investors who buy those shares must buy dollars first, and many leave the currency exposure unhedged.

Tariffs and deficits

The incoming administration's plans add to the dollar's strength in the short run. Tariffs reduce American demand for imports, and so for foreign currency, which tends to push the dollar up. Countries facing tariffs may also let their currencies weaken to offset the duties, as China did in 2018 and 2019. Large budget deficits keep the Treasury borrowing heavily, which supports yields. Together, loose fiscal policy and a cautious central bank are a classic recipe for a strong currency.

Trade threats have hit the currencies of America's closest partners hardest. After Mr Trump said in late November that he would impose 25 per cent tariffs on all goods from Canada and Mexico on his first day in office, the Canadian dollar fell to its weakest level since the pandemic shock of 2020. Currencies of countries that sell heavily to America now carry a tariff discount that has little to do with their own economies.

A precedent from the 1980s

The same recipe was tried under Ronald Reagan. Big tax cuts and military spending widened the budget deficit, while Paul Volcker's Fed kept rates high to crush inflation. The dollar soared through the first half of the decade, American manufacturers lost ground to foreign competitors, and the trade deficit ballooned. By 1985 the damage was severe enough that the leading economies agreed at the Plaza Hotel in New York to push the dollar down together. More recently, the dollar hit a twenty-year high in September 2022 as the Fed raised rates aggressively, then fell back as inflation eased and the rate gap narrowed.

Winners and losers

A strong dollar is good for American consumers and tourists, who find imports and foreign holidays cheaper, and for exporters in Europe and Japan, whose goods become more competitive. It hurts American multinationals, whose overseas earnings are worth less when converted into dollars, and American manufacturers that compete with imports. The greatest strain falls on emerging-market governments and companies that borrowed in dollars, since their debts grow in local-currency terms as their own currencies fall. Commodities priced in dollars become dearer for buyers elsewhere, which weighs on demand.

The case for a turn

There are reasons to doubt the dollar can keep rising. By most measures of purchasing power it is expensive against other major currencies. Tariffs could slow American growth, and if the Fed eventually cuts more than it now signals, the rate gap would narrow. Mr Trump complained about the strength of the dollar during his first term, and during this year's campaign he again described a strong dollar as a problem for American manufacturers. A deliberate effort to weaken it, whether through pressure on the Fed or negotiations with trading partners, cannot be ruled out.

These risks are real, but they are longer-term. None of them changes the fact that American growth and yields are higher than those elsewhere today, and currency markets tend to follow those gaps until something closes them.

What to watch

The key indicators are the relative paths of growth and interest rates: American data against the eurozone's and China's, and the Fed's actions against those of the ECB and the Bank of Japan. The tariff announcements after 20 January will shape the near term. A sign that the administration is seeking a weaker dollar, or a sharp slowdown in American growth, would be the clearest signals of a turn.

The dollar’s run in 2024 reflected faster American growth and higher American rates. As long as both gaps stay wide, it will probably stay on top in 2025, to the discomfort of anyone who borrowed in it abroad. Expect the dollar to hold its strength through at least the first half of next year, with emerging-market borrowers and American exporters paying the price.