U.S. monetary policy is zigging while the rest of the world is zagging, and the world should brace for a protracted dollar surge, more strains for developing economies and volatility in global markets.
After two weeks of signaling by central banks, investors are betting the Federal Reserve will raise U.S. interest rates within 14 months. No similar move is seen in the euro zone, Britain or Japan before 2016 at the earliest, the first major divergence in rate expectations for five years.
Prospects of less Fed money printing and the European Central Bank's promise this week to keep interest rates low have already pushed the gap between U.S. and German 10-year government bond yields to its widest since 2006.
The developing policy gap, and the United States' stronger economic outlook, means many investors are starting to assume the dollar is in the foothills of a mountainous rally.
That could provide a fillip for struggling European and Japanese exporters but would be bad news for emerging economies.
A stronger greenback has a depressive impact on dollar-priced commodities, raises dollar borrowing costs for companies and developing countries, and may ultimately stem the flow of U.S. investment overseas.
Almost half the world's $80 trillion of private pension, insurance and mutual fund savings originates in the United States, and long-term shifts in the dollar's exchange rate can profoundly change their calculation of overseas returns and hence their preference for home or foreign markets.
"It's potentially going to have a big impact on the dollar and U.S. fund managers who are the biggest investors in the global economy," said UBS strategist Manik Narain.
"They have been orchestrating the big inflows into emerging markets and now for the first time in 13 years they are seeing real U.S. interest rates are on the rise."
The dollar has risen sharply against Japan's yen and emerging market currencies all year, but the latest shift in monetary outlooks within the developed world looks likely to push it up against the euro, sterling and other G7 currencies.
"We're big proponents of a stronger dollar, it's the central investment thesis of this period," said Scott Thiel, head of global bonds at the world's biggest asset manager, BlackRock, which has almost $4 trillion under management.
Others say the order in which countries were sucked into the global crisis is the main issue. But dollar strength still emerges under that scenario.
"There's potential for the appreciation of the dollar versus the euro and also against Asian currencies," said Arnaud de Servigny, chief investment officer at Deutsche Bank Wealth Management. "The entry into the crisis was the U.S. first, followed by Europe, followed by Asia. Now the first out is the U.S., followed by Europe, and there's some uncertainty in Asia."
Prolonged periods of broad dollar strength have been few and far between since exchange rates were allowed to float in 1973.
Seismic dollar swings in the 1980s also resulted from mismatched economic cycles and monetary policies either side of the Atlantic and were met with bouts of central bank intervention, first to cap the dollar and then to stall its subsequent collapse.
Investors are looking at 1994 as a parallel for the present. Surprise Fed rate rises that year pushed bond yields higher everywhere, even as Germany's Bundesbank, then Europe's most powerful central bank, was furiously easing policy.
The interest rate gap peaked in 1995, the trigger for six years in which the dollar, still the world's main reserve currency, appreciated more than 40 percent on the Fed's broad trade-weighed index.
While the dollar has been gaining strength, the Fed's broad dollar index has risen only 4 percent so far this year.
The late 1990s saw major crises in emerging markets as dollar strength tightened global financial conditions and depressed world commodity prices, and as U.S. money returned home to what was seen as a relatively safe high-growth story in Silicon Valley.
This week's historic decisions by the ECB and Bank of England to offer "forward guidance" on interest rates stands in contrast to the U.S. Federal Reserve's timetable for less money printing and higher rates over the next two years.
With Japan also still in the midst of a renewed and aggressive monetary easing, the Fed's relatively hawkish leaning looks out of step with its major Group of Seven allies.
And despite attempts by Fed officials to emphasize conditionality, a hefty 195,000 rise in U.S. non-farm payrolls in June will only reinforce that view.
But could a dollar rise itself be enough to make the Fed row back?
Jim O'Neill, former chairman of Goldman Sachs Asset Management and long-term proponent of emerging economies, told Reuters on Friday that the exchange rate fallout may be critical in shaping "reaction functions" around the world.
"The dollar is likely to rise but the Fed doesn't want to preside over a major tightening in financial conditions and so a huge dollar rise may itself contribute to the Fed toning down what it said," said O'Neill.
Big developing countries like China could also help themselves, by further reducing their dependence on the dollar for trade and investment, he added.
"The notion that emerging economies are always vulnerable to the curse of the dollar's exorbitant privilege is in their own (emerging countries') hands."
© 2015 Thomson/Reuters. All rights reserved.