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The dollar can extend its gains if markets continue to treat the Federal Reserve as free of political pressure, although America's wide budget deficit remains a medium-term risk.
The dollar has cleared one of the biggest hurdles to further gains as markets regain confidence in the Federal Reserve's independence, says a new FX market analysis from Rabobank.
"Diminished fears about political interference on the Fed is a supportive factor for the USD," says Jane Foley, Senior FX Strategist at Rabobank.
Fed Governor Christopher Waller said in a speech on Tuesday that a 50 basis point hike should be considered in December, hours before October's U.S. inflation figures came in hotter than expected.
"Not only is the market now fully priced for a December rate hike, but importantly the comments were met with no real speculation that the Fed would be pressured by political forces not to raise rates," she adds.
Rabobank says fears about the Fed's credibility have dissipated since Chair Kevin Warsh surprised markets with a hawkish position at the Jackson Hole symposium in August.
The bank also says last week's midterm elections, which handed Democrats both houses of Congress, give less reason to expect pressure on the Fed from the White House.
President Trump has appointed three of the Fed's seven governors, including Warsh, and is trying to remove Governor Cook, a Biden appointee whom the courts have allowed to stay in post while she challenges the attempt.
Political commentators suggest a Democratic Senate could refuse to confirm a successor of Trump's choosing should Cook be forced out.
"In short, markets have inferred that last week's mid-term election result suggests that the issue of Fed credibility is likely to be diminished over the remainder of Trump's term," says Rabobank's Foley.
The euro-to-dollar exchange rate fell 3.8% from mid-September to a low of 1.1105 on 29 October, and a post-midterm rebound to 1.1273 has since faded to 1.1168, leaving Rabobank's three-month forecast of 1.10 some 1.5% below spot.
Rabobank points to strong demand for the dollar at the start of the Gulf war as evidence its haven status survived last year's doubts, "in our view the USD's safe haven appeal is linked to its embedded position in global payments systems, which could take decades to shake," says Foley.
The bank expects the European Central Bank to raise rates in December but judges market pricing for further hikes in 2027 too aggressive, and it flags uncertainty over what a far-right president in France could mean for EU cooperation.
"The stresses that the EUR could face in the coming months could support a preference for long USD positions," says Foley.
Rabobank expects the pound to hold up better than the euro, with three-month forecasts of 1.34 for GBP/USD and 0.82 for EUR/GBP (GBP/EUR 1.2195).
However, Rabobank warns that America's budget deficit, above 6% of GDP and wider than France's, could weigh on the dollar over the medium term.
The bank sees signs that the 'exorbitant privilege' of cheap U.S. borrowing has slipped, including uncomfortable selloffs in Treasuries over the past 19 months and volatile results at some longer-dated auctions.
"Either way, last year's dollar debasement fears appear exaggerated," says Foley.
Pound Sterling Live's House View modelling holds that the dollar's route to outperformance runs through Fed expectations and two-year yields, and a Fed seen as free to hike keeps that route open.
The dollar should hold its gains against the euro for as long as markets treat the Fed as free to tighten, with Rabobank looking for EUR/USD at 1.10 within three months.
