By Jamie McGeever

ORLANDO, Florida (Reuters) – Politics is often a major driver of exchange rates in emerging economies, where elections, leaders, and government policies can shape trade and investment flows. This is not as often the case for major currencies, like the U.S. dollar, which has much deeper investment flows and liquidity.

However, the dollar's explosive rally following the U.S. presidential election shows that politics still matter significantly for the dollar. The greenback is highly sensitive to political shocks.

The dollar surged nearly 2% against a basket of major currencies early on Wednesday after Republican Donald Trump won decisively over Democrat Kamala Harris in Tuesday's election. This marked the dollar's biggest one-day rise in over eight years, specifically since June 24, 2016, following the Brexit referendum in the UK, which saw a dramatic drop in sterling.

Trump's victory was less shocking than Brexit, and financial markets had anticipated it. However, the dollar's sharp reaction suggests that the margin of victory and the likelihood of Republican control of both houses of Congress caught markets off guard. Steven Englander, head of G10 FX strategy at Standard Chartered, noted the potential for a “clean sweep” and the current polarized political environment.

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The dollar rarely fluctuates by 2% in a day due to the vast flows required to move such a heavily traded asset. The greenback appears in 90% of all foreign exchange trades, with the global FX market's average daily turnover at $7.5 trillion.

Since 2016, the dollar's daily gains have been around 1.5%, primarily during the volatile early days of the pandemic or during the height of U.S. interest rates in September 2022. Extreme declines have also been rare, typically occurring around the pandemic or when soft inflation data was released.

The 2024 U.S. presidential election, like Brexit, serves as a reminder that political shocks can have a considerable instant impact on highly liquid currencies.

The larger question is whether such extreme moves have long-term effects, and the answer is they can. Sterling, for instance, has not returned to its pre-June 2016 heights and has lost 10% against the dollar and 25% on a trade-weighted basis, effectively reducing Britain’s global purchasing power.

While a near-decade-long rally for the dollar is unlikely due to numerous domestic and global factors, expectations are for the new administration’s policies to push inflation, bond yields, and the dollar higher.

Mizuho's FX strategy team suggests the dollar could see another 4% upside before it matches its gains from 2016. Barclays analysts agree that the dollar has potential for further strengthening, possibly pushing the euro down to $1.03 in the near term, depending on Republican success in elections.

It is impossible to precisely predict the future, but investors are reminded that political shocks can influence even the most liquid markets, such as the U.S. dollar.

(The opinions expressed here are those of the author, a columnist for Reuters.)

(By Jamie McGeever; Editing by Cynthia Osterman)