By Matt Peterson

Jerome Powell spoke and the dollar jumped.

That was one of the surprising consequences of the Federal Reserve chair's Dec. 18 news conference. Powell and his colleagues had opted to lower interest rates by a quarter point. In general, lowering a country's interest rate might be expected to weaken the attraction of its currency, since investors could potentially earn a better return elsewhere. But the dollar isn't like other currencies.

The U.S. Dollar Index, or DXY, which ranks the dollar against a basket of currencies, was up nearly 7% in 2024, adding to a longer strong run by the currency. That's despite Fed rate cuts, persistent worries about the stability of U.S. finances, and other macroeconomic concerns. How President-elect Donald Trump's plans for tariffs, tax cuts, and the Fed will affect the dollar is a crucial question for investors in 2025 and beyond.

For a read on dollar dynamics, Barron's reached out to Karthik Sankaran, a former foreign-exchange trader and portfolio manager. Sankaran's insights on macro strategy -- and his hand-drawn charts and legendary dad jokes -- have won him a devoted following in the markets.

Sankaran recently joined the Quincy Institute for Responsible Statecraft as senior research fellow in geoeconomics in the Global South program. The Quincy Institute is a think tank that advocates for restraint in U.S. foreign policy.

We spoke over the phone on Dec. 19, the day after the Fed meeting. An edited transcript of our conversation follows.

Barron's: The dollar dipped during the pandemic but has largely risen since then. What explains that?

Karthik Sankaran: There are a few reasons why the dollar has been as strong as it has. The initial pandemic saw the dollar strengthen just because there was an initial knee-jerk response of flight to safety back into the dollar in March 2020 and soon after. But after that, the scale of the Fed response and its efforts to try and put a cushion under the economy meant dollar strength didn't persist.

Where you really start getting a much bigger move up is in February 2022, with the Russian invasion of Ukraine.

Why was that?

Everything kicked in for the dollar. You had a massive energy shock that hit Europe especially hard. It weighed on the euro and it weighed on Japan because of what the Russian invasion did to global energy prices.

You had a traditional safe-haven flow into the dollar, exacerbated at this point by the fact that this was not a financial safe haven but a geopolitical one, where U.S. credentials are even stronger. The euro traded below parity [one dollar per euro] in summer 2022.

With the end of 2022, you started seeing not just more inflationary pressures in the U.S., but also a response by the Fed that was clearly going to be hawkish. Those three things together all meant dollar strength.

Now, if I can kind of rewind a little bit to 2014, I think that's when you get a more long-term story in the dollar, which is U.S. shale production. That's really important, because what it meant was that while the U.S. could continue to run -- and would continue to run -- large trade deficits, they were no longer driven by the petroleum deficit when energy prices rose.

Over a relatively short space of time, the U.S. goes from being an energy importer to being an energy exporter, and the dollar acquires the attributes of a commodity currency. It starts behaving more like the Australian dollar or Canadian dollar because, if I wanted exposure to a currency that strengthens when commodity prices rise, guess what? The U.S. dollar is now one of them.

The DXY index rose 1% after the Fed cut interest rates on Dec. 18. Can you explain that?

There's the specific mechanics: They took one rate cut out [of their expectations for 2025]. They raised the 2025 core personal consumption expenditure inflation forecast more than they raised the growth forecast. And so on.

But reading between the lines of the press conference, what I thought I heard was something that went, "OK, officially we're still discussing [the effects of Trump's agenda], but we have a sense that Trump's fiscal policy is going to add a little bit to demand. And Trump's tariff policy will have the same price effect as reducing supply from the rest of the world, which together means we won't be cutting quite as much."

If you get a combination of tariffs and fiscal policy leading to a strong dollar, to a significant portion of the world, particularly in the global south, it will tighten financial conditions. It makes borrowing more expensive.

Those things together can mean people start worrying more about growth outside the U.S., which can then be exacerbated in flows back into the dollar. There's kind of a vicious circle. Dollar strength can be exacerbated by worries about the financial stability impact on the rest of the world. The effect of that is to actually push more money into the dollar and into the U.S. system.

So, you think that tariffs and tax cuts together are likely to continue to drive up the dollar?

Yes, for now. And that's where you get to the other part of the question, which is, what would happen if some other country tried this? What would happen if another country said, "OK, we're going to put up massive tariffs, keep out some technologically advanced imports to focus on domestically made goods, and we're going to blow out the budget deficit." As a longtime emerging markets guy, I can tell you what would happen: That currency would tank.

Why doesn't this happen to the U.S.? That's in part because the negative impacts of this ripple out to the rest of the world. The U.S. is the world's largest importer of manufactured goods. Tariffs have the potential to slow growth outside the U.S., which can make those markets somewhat less attractive, so money flows back in.

People don't react to the U.S. doing things that would roundly tank the Argentine peso or the Malaysian ringgit if Néstor Kirchner or Mahathir Mohamad had tried them.

You said "for now." Will this effect be temporary?

I can't really go into prognostication, but I think there are ways in which the market might end up reacting negatively to some of these things. The most obvious one is Fed policy. In developed markets, people look at signs of inflation, and they'll pile into [a currency]. The embedded expectation is that the central bank will be allowed to do its job and hike interest rates, or not cut them.

The classic example is 1981-85 in the U.S., where you had large fiscal deficits driven by the combination of the Reagan tax cuts and increased defense spending, but U.S. interest rates were high. And the markets said, "OK, we don't care. We don't care that much about the large fiscal deficit and the large trade deficit. We are getting high rates here. So we're just going to pile in."

The question now is to what extent U.S. political economy is prepared to go through that similar cycle. The signals are mixed. Trump's first term was one in which he said that he preferred a weak dollar. He didn't like Powell. If that kicks in again, then that might be something that starts to weigh on the dollar.

That's something to keep an eye on. Powell's term is up in May 2026. If there are indications that Trump wants to go with someone less orthodox in terms of monetary policy, then that might be one thing that leads to dollar weakness.

If markets think that monetary policy isn't going to respond to the potential inflationary impact of fiscal expansion, coupled with tariffs, that would not be dollar-positive.

A compliant pick for the Fed could precipitate a pullback in global investors' willingness to invest in U.S. assets.

Yes, I think so. My sense is that markets will tolerate fiscal heterodoxy. They will not tolerate a combination of fiscal heterodoxy, trade heterodoxy, and monetary-policy heterodoxy. That's a trifecta of bad things, basically.

China and Saudi Arabia are attempting to use China's renminbi instead of the dollar to settle some of their oil trade. That has led to some worry about the dollar's role as the global reserve currency. Is that meaningful?

At the margin, maybe. But the argument I've always made is that what matters isn't what you settle trade in.

The most important function of the dollar in the global financial system is not that it is the leading reserve asset. It's the fact that it's the leading nomination of cross-border debt, which is a private-sector thing. Is the renminbi a currency that can be used for large-scale issuance in deep, liquid markets by non-Chinese borrowers? We're a very, very long way from that.

The renminbi is nowhere near ready for prime time. That won't change until you get a large amount of issuance in renminbi, including by non-Chinese issuers.

The time to get excited isn't when China and Brazil are trading in renminbi. It's when Vale, the giant iron ore company, is issuing in renminbi. Then the Saudis, who are getting renminbi for the exports of oil to China, can buy something else that's in renminbi that isn't Chinese. That's when it even starts to do some of the things that the dollar does in the world. And we're nowhere near that.

You are concerned about stablecoins. These are cryptocurrencies that are pegged 1-to-1 to the dollar. Why are you worried?

Stablecoins expand the dollar's financial footprint dramatically. What you're doing is allowing access to dollars to change the currency of your savings on a massive scale across countries. It's not clear to me that the U.S. wants that.

I personally believe the world would be better served by a multipolar financial system, even though I think we are far away from that for the reasons I just mentioned regarding China. The U.S. still dominates the global financial cycle. But the global real cycle is set elsewhere. China is a very significant part.

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