Will the Dollar Continue to Strengthen in 2016?

The US dollar has been on the rise over the last year, an unusual occurrence for the greenback, which has mostly declined in value compared to the currencies of other wealthy nations over the last 4 decades. The immediate cause behind increased demand for the dollar this year was the mounting expectation that the US Federal Reserve would increase interest rates this year. However, the driving mechanism behind the rising value of the dollar was the strong performance of the US economy.

 

Indeed, it was the strength of the US’s economic indicators that encouraged the Fed to finally make a move on its interest rate. After failing to do so in its September meeting, the Federal Reserve hiked its benchmark interest rate in December by 25 basis points to between 0.25 %and 0.50%. The decision marked the end of a loose monetary policy that the Fed had implemented since mid-2006.

 

 However, even though an increase in interest rates typically suggests that the value of the local currency will rise, December has been a sluggish month for the dollar. The dollar index, which tracks the greenback against a basket of its peers, is down 0.4 per cent today, resulting in 2.1% decline this month.

 

What expectations, therefore, can we have for the dollar following a month-long decline in the context of a year of growth?

 

Although it is true that the dollar has had a weak December, the strength of the US economy and the expected long-term pressure on oil prices suggest that the dollar should remain strong throughout 2016.

 

The reason December has been slightly underwhelming for the dollar is due to the fact that currency markets had been expecting a Fed interest rate hike for so long that the value of the currency rose in anticipation of the actual decision. Once the decision was finally made investors didn’t feel the need to react to news they had already taken into account, namely the strong performance of the US economy. 

 

Moreover, in recent weeks the dollar has been in decline as it responds to the decline in US equities that are in turn driven by the constant pressure energy prices face. Investors reacted negatively to the low demand in oil that they have interpreted as a sign that the global economy is slowing down. However, in the long term we can expect oil and the dollar to maintain their inverse relationship.

 

As oil prices decline, the costs of goods and services requiring oil become cheaper, which will further strengthen the US economy and in turn raises the value of the dollar. 

 

Moreover, volatile in markets encourage investors to seek haven assets including US treasury bonds which increase the demand and therefore the value of the dollar. Given that oil prices are expected to remain depressed in the near term, this factor should encourage the continued strength of the dollar throughout the next year.

 

Another likely cause for the increased value of the dollar in 2016 is the potential of additional Federal Reserve Rate increases throughout the year. The Fed will continue to base its gradual increases of the interest rate on the economy. Given that recent economic indicators show promise, gradual increases in the interest rate can be expected in 2016 as will its consequent boost on the dollar.

 

The current outlook of the US economy is encouraging. A recent report reflected that consumer sentiment was at a 5 month high in December. Meanwhile, personal income rose for 8 consecutive months in November.  Unemployment is likewise very low, with the Federal Reserve considering current rates consistent with full employment. These factors are expected to increase consumer spending, and generate economic growth.

 

Trade24 notes that although other factors certainly play a role in the value of the US currency, the strength its economy currently demonstrates and the likelihood of gradual increased interest rates suggest that the dollar will remain on the rise next year. 

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