In the past year, the U.S. dollar has risen nearly 20 percent against a basket of major currencies. But according to some analysts, the real dollar move will come when the Federal Reserve finally raises its short-term interest rate targets.
Many have credited the greenback's surge on expectations of a U.S. central bank hike. But according to a study by Bank of America Merrill Lynch, only 3 percent of the dollar's move can be ascribed to shifting Fed expectations (Based on an analysis of S&P 500 and Treasury note moves that sought to identify the catalyst behind any particular one-day day action).
And since the dollar does tend to rise when the Fed raises rates, the BofAML global rates and currencies research team goes on to conclude in a Friday report that "The dollar has more room to strengthen when the Fed actually initiates hikes," particularly given that other major monetary authorities like the European Central Bank and the Bank of Japan remain in easing mode.
"The thing about the currency markets is they tend to have very, very long cycles," commented Boris Schlossberg, a currency trader at BK Asset Management. And given current central bank policy divergence, "the dollar definitely has a tail wind behind it—it's definitely poised for further movement to the upside."
In other words, the currency market doesn't price in expected moves as quickly as other markets, leading to the potential for trends to perpetuate over long periods of time.
Schlossberg warns that it remains unclear whether the Fed hike will come in September, in December, or perhaps later, so the dollar may not make a good short- or medium-term buy.
Still, if one believes a September hike is coming, initiating a long dollar position—say, by buying the PowerShares Dollar Index Bullish ETF (UUP)—might be the best way to express that thesis.
Rising rates tend to help a country's currency, given that they increase the risk-free return that currency holders can receive.