Dollar rally has long way to go

The dollar is flexing its muscles on the prospect of higher U.S. interest rates, and it may be only half way through a dramatic move that is jarring global currency, bond, commodity and stock markets.

The dollar index touched a new 12-year high Tuesday, and is now up 3.3 percent for the month of March. The yen slid against the greenback and the euro waffled, edging closer to parity at $1.07 against the dollar. Emerging market currencies also sold off, with the Mexican peso plumbing a new all-time low.

The strengthening dollar leaves plenty of losers in its path, including oil and other commodity markets, emerging markets and potentially even the U.S. stock market, vulnerable to the strong dollar's impact on corporate earnings. Gold, for instance, was near its lows of the year Tuesday, at $1,159 per ounce.

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An employee counts euros and U.S. dollar notes in a currency exchange store in Lisbon, Portugal.
Mario Proenca | Bloomberg | Getty Images
An employee counts euros and U.S. dollar notes in a currency exchange store in Lisbon, Portugal.

Diverging central bank policy has created a perfect launch pad for the dollar to move higher, particularly against the euro. The Fed is expected to push interest rates higher in the next several months, while the European Central Bank embarked on a quantitative easing bond buying program Monday.

"Year to date, the euro's down 11 percent. This is only March. Do we have another 7 percent before the end of this year? I don't see why not," said Marc Chandler, head of foreign exchange strategy at Brown Brothers Harriman. "We're only about half way to where we're going (against the euro). ...There's another 30 cents or so on the downside."

Chandler said the euro could be setting up to retest its all-time low just above 0.82 to the dollar by 2016.

David Woo, currency and rates strategist at Bank of America Merrilll Lynch, said the winners and losers are lining up. For instance, the correlation between the rising dollar and and the S&P 500 has turned very negative over the past four to six weeks.

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"As the euro/dollar goes down it's going to be deflationary for everybody else. It's going to be bad news for emerging markets," said Woo. He said China could possibly be forced to devalue its currency as the euro sags against the dollar. Europe is China's biggest export market.

"That's why it's the currency wars. Someone wins. In this case, it's clearly Europe," said Woo, noting the U.S. stock market is flattish this year, while European equities are performing better.

Woo said Europe's bond buying is pressuring the euro, and could continue to do so as foreigners sell bonds into the ECB's QE program. He estimates as much as $120 billion euros could be sold annually due to QE. "If foreigners are selling the bonds, they're selling euros, too. The actual start of ECB bond market purchases is going to generate euro selling," he said.

While the dollar is on a longer-term trend higher, some strategists say it may be ready to take a breather. UBS managing director Paul Richards said he sees the euro at $1.07 on the dollar and dollar/yen at 122, as stretched valuations.

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"I remain constructive on the dollar medium term," said Richards, adding the Fed is likely to begin the rate hiking process in June, then hike again in October and December.

"I think the euro is going to parity in 2015 and back to 90 [cents] in 2016," said Richards. "I remain constructive because of the Fed's actions on QE. When the world was doing nothing, they got ahead of the game and we've seen the economic benefits to the U.S. and I think ultimately that will benefit the U.S. dollar."

Chandler said investors are now paying more attention to the impact of the rising dollar. "Hedging currency risk becomes more important in a strong dollar environment," he said.

Emerging markets are feeling the pain. Turkey, too, saw its currency fall to an all-time low against the dollar.

"Emerging markets have generally required four things: one, a weak dollar; second, strong commodities prices; third, strong world growth; and the fourth thing is about Fed policy," he said.

Chandler said he expects to see sovereigns and corporates that borrowed in dollars look to exit some positions. "Now the dollar is expensive. They want to get out of it, and they don't want to take the pain anymore," he said.

Clarifies that euro could fall to $0.82 against the dollar