(Bloomberg) -- There’s a subtext to this year’s blistering rally in US risk assets: When it comes to the dollar, there is no alternative.

The greenback is just shy of the record it reached during the pandemic and on pace for its best year since 2020. As measured against the currencies of America’s largest trading partners, it’s a lofty 17% above its average over the last two decades. 

Wide-ranging indicators of continued US strength have fueled the recent gains, and the economic resilience has forced traders across markets to rapidly dial back expectations for imminent monetary easing by the Federal Reserve. Dollar bears now face the prospect of higher-for-longer benchmark rates that should bolster the US currency. But the dollar’s vitality goes deeper than that.

Key pillars of support — from US productivity growth and economic dynamism to a torrent of flows into American assets and homegrown technological prowess in crucial areas such as AI — reinforce the greenback’s dominant role as the world’s reserve currency despite any short-term ups and downs. These fundamentals should blunt the impact of Fed rate cuts when they do happen, and, by keeping the US economy in front of global peers, underpin the narrative of “American exceptionalism” for the foreseeable future.

“There’s zero alternative,” said Themistoklis Fiotakis, head of foreign-exchange strategy at Barclays Plc in London. “Dollar strength is about longer-term macro factors. It’s not a cycle, it’s a trend.”

In recent weeks, big players have thrown in the towel on bearish bets made in December. Non-commercial traders — a group that includes hedge funds, asset managers and speculative investors — have pared short dollar positions to the point where they are effectively flat, according to the latest data released by the Commodity Futures Trading Commission. 

The repricing of Fed expectations has been “a huge adjustment,” said Candice Bangsund, a portfolio manager at Montreal-headquartered asset manager Fiera Capital. “Expectations have moved a lot in the bond market and obviously that flows into currency markets as well.”

This month, economists marked up their forecast for 2024 US growth to 2.1% and lowered the odds of a coming recession to 40%, according to the latest monthly Bloomberg survey of economic forecasters.

“If US growth remains the highest among the major developed markets and the dollar interest rates don’t fall that much, there is certainly no reason for the dollar to weaken,” said Kiyoshi Ishigane, chief fund manager at Mitsubishi UFJ Asset Management Co. in Tokyo.

Read more: Dollar Strength Is Looking Like a New Normal: John Authers

The US is reaping the benefits — at least for now — of a burst in productivity that could insulate the economy from a global slowdown. But the short-term effects are merely the byproducts of a more powerful underlying trend, according to Barclays’ Fiotakis.

“The US has invested and continued to double down on a business model that is mainly geared towards boosting the domestic economy in underappreciated ways,” Fiotakis said in an interview. He cited increased commodity production and the global reach of US-based Big Tech firms. 

The dollar’s gains this the year have also notably come alongside a surge in US equities — highlighted most recently by the rally in chipmaker Nvidia Inc.’s shares after its blockbuster earnings report last week — that has brought a steady supply of capital into the US. Such flows are indicative of long-term, consistent returns on capital that have also served to create a floor for the greenback.  

This year, a gauge of the “Magnificent Seven” group of Big Tech shares — which includes Nvidia as well as the likes of Alphabet, Apple and Microsoft — has returned about 13%, compared to less than 5% for a measure of global stocks. Since 2015, the Magnificent Seven has outpaced the broader group many times over.

Read more: AI Mania Resumes, With Nvidia Outlook Saving Broader Market

The prospect of strong returns from US assets support the dollar and “prove a hard bar to beat,” wrote a group of Goldman Sachs currency strategists led by Kamakshya Trivedi in a recent note to clients, although they added the dollar has now reached or “overshot” the firm’s near-term forecasts.

In a separate report last year, Goldman macro strategists estimated the US share of global portfolio investment assets rose to around 26% by 2022 compared to roughly 16% in 2005.

The US outperformance comes amid sluggish growth in Europe, where recent Eurostat data indicated economic activity stagnated at the end of 2023, and as concerns mount around an ailing Chinese real estate sector. In China, balance of payments figures for last year showed foreign direct investment increased by the lowest amount since the early 1990s.

“It’s hard to say that dollar strength is purely cyclical,” Meera Chandan, co-head of global foreign-exchange strategy at JPMorgan Chase, said in an interview. “There’s a yield exceptionalism, there’s a growth exceptionalism, and equity market returns have been exceptional compared to Europe and China.”

JPMorgan strategists see the euro weakening to $1.05 by the middle of the year, from around $1.0850 currently, and the firm’s index of the broader dollar gaining slightly by June before slipping lower into year-end. 

In the options market, there are some signs the dollar’s momentum is fading. Risk reversals, a barometer of market sentiment and positioning, show traders are split over the greenback’s prospects over the next month. Longer-term bets point to the least bullish outlook since May.

Dollar dominance also has its side effects. In the US, a stronger greenback can drag on corporate profits by weighing on sales abroad — a key risk international investment firm the Carlyle Group recently called out in its annual report.

For other nations, a highly valued greenback is more than just a headache. It raises the costs of imports, boosts inflationary pressures, and can back monetary policymakers into a corner, necessitating higher interest rates in order to stem capital flight.

Read more: The Dangers of Relying on the US to Power the Global Economy

What Bloomberg Strategists Say...

Until the US economic narrative turns again — and we expect it will, with February data under close scrutiny — short-term Treasury yields may remain sticky. That will keep dollar bulls in better shape compared with 4Q.

- Audrey Childe-Freeman, chief G-10 FX strategist. For the full note, click here.

Then there’s politics and policy, which pose their own risks. Some Wall Street strategists think the increasing likelihood of a Donald Trump US presidential candidacy will be near-term positive for the greenback as proposed policies — such as universal, 10% tariffs on imported goods — could ultimately support the US trade balance in the immediate future. But the risk of blowback could imperil the dollar’s status, alongside a potentially toxic mix of deteriorating governance and a surge in US deficits. 

“Thanks to the US dollar’s status as reserve currency, the US has had the luxury of being able to run a large deficit,” wrote Johanna Kyrklund, group chief investment officer and co-head of investment at Schroders, in a recent note. “However, signs of fiscal profligacy from candidates may push the patience of markets too far.”

So far, these factors have yet to dent the global pre-eminence of the US currency — or the patience of the markets it supports.

“This is an enormous issue for international investors, what to do with this massive US market that has become 60% plus of world equities, world bonds,” Jan Loeys, a senior advisor on long-term strategy at JPMorgan, asked on a recent podcast. “Can you ignore this market?”

--With assistance from Robert Fullem, Masaki Kondo, Ruth Carson, Matthew Burgess and Vassilis Karamanis.

(Updates prices, adds context on positioning in the option market in the 19th paragraph.)

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