Last week, speculators pulled funds out of emerging-market currencies. One reason was that the Chinese economy underperformed expectations in January, weighing on demand for output from emerging markets, which rely heavily on China for their exports.
Meanwhile, the Federal Reserve cut its stimulus program, pushing interest rates higher. The reduction of excess capital by tightening policy led the Reserve Bank of India to question whether the Fed knew its choices had a global impact.
In an effort to curb outflows of capital, Turkey, South Africa and India all raised their benchmark rates over the past week. The strategy may help stabilize currencies in the short term, but ultimately higher rates will weigh on growth and investment.
Analysts see further selling in emerging-market currencies, which should drive the U.S. dollar higher.
Furthermore, the eurozone released an inflation figure last week of 0.7% annual growth, well below the European Central Bank target of 2%. Such tepid price increases in Europe have brought about fears of deflation.
The ECB meets on Thursday to discuss policy, and deflation will certainly be one of the points of interest. Although the ECB may not cut rates again, it may consider some other form of stimulus.
In either case, deflation is an issue, and with policy in both the U.S. and Europe beginning to diverge, expect the dollar to outperform the euro in the months to come.