By Saqib Iqbal Ahmed

NEW YORK (Reuters)

Donald Trump’s imminent return to the White House is putting a spotlight on the U.S. dollar, with potential implications for domestic manufacturers and emerging markets if the currency's rally continues.

The U.S. currency achieved its biggest one-day gain against its peers in eight years on Wednesday, following Trump’s re-election and the Republicans winning control of the Senate while gaining seats in the House of Representatives. The dollar is up 3.8% this year, reaching its highest level in four months.

How far the dollar climbs could depend on investors' beliefs about Trump enacting key tax cuts and tariffs. While such policies might boost growth, they could also drive inflation higher, keeping U.S. interest rates above those of other countries and increasing the dollar's appeal to investors.

Conversely, a strong dollar could negatively impact U.S. companies, a concern expressed during Trump’s first term.

> "A Trump administration likely means more spending, a hotter economy and high bars for international trade – all things that spell strength for the dollar," said Helen Given, associate director of trading at Monex USA.

RATES TRAJECTORY

The trajectory of interest rates is critical to the dollar’s future. The Federal Reserve began its current monetary easing cycle with a 50-basis-point rate cut in September and may announce a 25-basis-point reduction on Thursday.

Lowered rate expectations had weakened the dollar earlier this year. However, the prospect of rising inflation could make the Fed cautious about over-cutting rates. Recently, traders adjusted their expectations for future rate cuts to about 42 basis points, down from 62 basis points last month, according to LSEG’s calculations.

> "I would describe this as a tectonic shift in currency markets," remarked Paresh Upadhyaya, director of fixed-income and currency strategy at Amundi US. Investors must now consider tariffs, inflation, global growth implications, and the Fed’s potential reactions.

A so-called Red Sweep scenario, where Republicans control both the White House and Congress, may facilitate Trump's tax cuts and overall economic agenda. Republicans retain at least a 52-48 majority in the Senate, while control of the House remains uncertain with vote counting ongoing.

Brad Bechtel, global head of FX at Jefferies, speculates that the dollar could rise another 5% under a Red Sweep scenario as Trump's policies are enacted. Trump's inauguration is set for January 20.

In 2016, the dollar rose 6% against other currencies in the two months following Trump's election but later lost those gains. It rallied about 13% from February 2018 to February 2020 during Trump’s implementation of tariffs against countries like China and Mexico.

RIPPLE EFFECTS

A rising dollar presents a dual challenge for the U.S. economy: it can suppress inflation but hurt the competitiveness of American products abroad. This can also squeeze profits for multinational companies converting foreign earnings into dollars.

According to a JPMorgan study, a 2% increase in the trade-weighted dollar diminishes S&P 500 earnings growth by 1%.

If the ascending dollar obstructs growth, Trump might urge the Fed to cut rates or pressure U.S. trading partners to elevate their currencies. Alternatively, he could consider the Exchange Stabilization Fund, which has about $215 billion, but there are doubts about its efficacy without global cooperation or Fed support.

> "Trump's preference for a weaker dollar would have to be accommodated by and in coordination with the Federal Reserve, which we view as unlikely," stated analysts at Wells Fargo.

Given the dollar's central role in global finance, its ongoing strength could impact other assets adversely. Emerging markets, especially those with heavy U.S. dollar loans, could face challenges repaying debts, prompting central banks in those countries as well as developed ones like Japan to raise rates to defend their currencies.

> "You're going to enter this new regime of currency war that used to flare up from time to time in the past," remarked Bechtel from Jefferies.

Some investors warn that tariffs could ultimately harm the U.S. economy by raising costs, disrupting supply chains, and diminishing trade volumes, thereby reducing the potential for dollar strength in the future. A Deutsche Bank study estimates that tariffs might cut U.S. GDP growth by approximately a quarter of a point if fully adopted.

> "The reality is that a full flight protectionist agenda will ultimately rebound on the American economy and slow growth," cautioned Karl Schamotta, chief market strategist at Corpay.