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Dollar is now caught in a tug-of-war between the Fed and Trump

The U.S. dollar spiked to a more than three-week high in the wake of the comments on Tuesday from Federal Reserve Chair Janet Yellen that prompted markets to assign a higher probability to the prospect of an interest rate hike as early as March.

The dollar index posted its fourth positive session in a row and its highest level since January 20 before slipping back only marginally in early trade on Wednesday as Yellen's remarks were interpreted as placing greater emphasis on the possibility of a hike at each upcoming meeting.

This although Yellen "danced it very well and avoided making any committal statement whatsoever," according to Jan Halper-Hayes, a Republican commentator and the former worldwide VP for Republicans Overseas, speaking on CNBC Wednesday.

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The reaction of the Fed funds futures market showed relatively muted optimism, with the read across from market levels indicating odds of 23 percent for a March hike, versus 16 percent earlier in the day, and a jump in expectations for a May hike to 50 percent from 38 percent, according to investment bank Jefferies.

While the upwards move in the dollar makes sense in the context of the latest news from the Fed, the near-term outlook for the dollar is uncertain given the conflicting force of President Donald Trump's anticipated economic policies, Richard Falkenhäll, senior FX strategist at SEB, told CNBC Wednesday via emailed comments.

As the new administration is likely to turn more expansionary due to lower taxes, the Fed may be propelled to tighten policy more rapidly, he suggests. This in addition to other potential changes such as the introduction of a border adjustment tax and a reduction of earnings retained from overseas should also be positive for the dollar, posits Falkenhäll.

"On the other hand, the Trump administration seems to prefer a weaker dollar and the behavior of the president since the inauguration probably motivates a political risk premium on the USD for now," he countered.

Indeed, Halper-Hayes cites President Trump's and Treasury Secretary Steve Mnuchin's attempts to talk down the dollar as one of her primary concerns.

"They don't believe in holding to the strong dollar policy … How are they going to abandon the strong dollar policy? If that happens what is that going to do? I see corporate earnings for global corporations, it would be very good but on the other hand what is it going to do to the domestic economy?" she asked, spelling out her apprehensions.

The ongoing debate over the dollar's strength follows an international flare-up last month, during which Peter Navarro, Trump's selected director of the National Trade Council, accused Germany of exploiting other countries by keeping the euro "grossly undervalued". Although Germany robustly defended the independence of the rate-setting European Central Bank (ECB), many commentators – including Germany's own Finance Minister Wolfgang Schäuble - did agree that the exchange rate was too low for Europe's largest economy.

Indeed, Germany's exchange rate is 15 percent undervalued, according to research released Tuesday by World Economics, whose World Price Index compares the fundamental purchasing power parity (PPP) values of currencies against market exchange rates. PPP looks at the cost to buy a hypothetical basket of goods in different countries and suggests currencies are in equilibrium when the basket is priced the same in each country.

The same research indicates that sterling is 9 percent undervalued following its slump in the wake of last June's Brexit vote and that the carefully managed Chinese yuan is 24 percent undervalued.

Weighing the conflicting factors, there is still a risk that the dollar could weaken in the near-term if the administration fails to deliver on the high expectations resting on it and causes an equity market sell-off, says SEB's Falkenhäll.

"However, medium term strong growth prospects for the U.S. and further tightening by the Fed this year are likely to maintain support for the dollar, which is why we expect it to trade between parity and 1.05 against the euro in the second half of this year," he concluded.

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