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Diverging Central Bank Policies Could Strengthen the Dollar

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Though currency market volatility is likely to continue, I still see a stronger dollar over the longer term. Here’s why:

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Diverging central bank policies

As the US economy continues to modestly strengthen, the Fed will likely begin raising rates later this year, and possibly as early as September. While the US tightens, most other central banks will likely remain in easing mode. (For more on this monetary policy divergence, check out the BlackRock Investment Institute “Diverging World” interactive graphic).

diverging central bank policies

Market Realist – Signs of a solid economy could mean rates could rise soon.

The graph above shows the annualized quarter-over-quarter growth in the US GDP (gross domestic product). The second estimate for the GDP growth in 2Q15 by the Bureau of Economic Analysis of 3.7% paints a merrier picture of the US economy than the first estimate of 2.3%. The economy rebounded in 2Q15 after a harsh winter and after the West port strike choked the economy in the first quarter.

The United States remains a bright spot among developed markets (EFA). Japan (EWJ) fell by 0.4% in 2Q15, while both Russia (RSX) and Brazil (EWZ) slipped into deep recessions due to the slump in commodity prices. China (FXI) is the epicenter of the global slowdown, which caused commodity prices to nosedive in the first place.

The United States is on stronger footing compared to most major economies. Recent reports also point to a solid if not booming economy.

Meanwhile, while the European economy is seeing green shoots of growth, it will still need more monetary stimulus to recover further. The Japanese economy has seen some signs of improvement since Shinzō Abe became prime minister in 2012, but it needs more reforms in order to see sustainable growth.

In this backdrop, it’s likely that central bank policies in developed markets would continue to diverge. The United States is likely to see rising rates in the next few years, albeit from ultra-low levels. Japan, Europe (IEV), and probably emerging Asia are likely to see easy monetary policies until the next year at least. This is likely to strengthen the US dollar (UUP) further.

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