The world's leading currency institute is bracing for a dramatic rise in the US dollar as the Federal Reserve rushes to tighten monetary policy, setting the stage for a protectionist showdown and a fresh debt crisis in emerging markets.

Adam Posen, president of the Peterson Institute for International Economics, said investors have badly misjudged the confluence of forces at work in Washington.

They wrongly assume that fiscal stimulus will come to little under Donald Trump, and are equally wrong that Janet Yellen Fed's will remain dovish as the US nears full employment.

"The Fed is going to be far more aggressive than people think. Our view is that there will be three to four more rate rises this year," he told The Telegraph.

This would amount to a global monetary shock, all the more so since the Fed is also floating plans to reverse quantitative easing (QE) by halting the roll-over bonds as they mature. This move to shrink the Fed's $4.5 trillion balance sheet may come earlier than originally supposed, perhaps by the end of the year.

The effect of Fed tightening would be to drain dollar liquidity from the international financial system, the exact opposite of what happened in the emerging market boom earlier this decade when so much of the Fed's easy money leaked into East Asia, Latin America, Africa, and the Middle East.

"We expect the dollar to rise by another 10pc to 15pc. The concern is that this will suck capital out of the more fragile emerging markets and lead to fresh capital outflows from China," Mr Posen said.

"It may vary country by country but it could be like the 'taper tantrum'. Malaysia and Brazil look vulnerable to us," he said, speaking at the Ambrosetti forum of global economists on Lake Como.

A hawkish Fed could prove painful for investors still hoping that central banks will come to the rescue whenever there is trouble, be it the 'Yellen Put' in the US,  the 'Draghi Put' in Europe, or the 'PBOC Put' in China.

The Fed is itching to show that it is not a prisoner of Wall Street, after being forced to retreat many times in recent years. It effectively delayed rate rises last year due to China’s currency scare. Now the coast looks clear.

"Central bankers don't think policy should be constrained just because somebody in the markets is going to lose money," Mr Posen said.

David Fuller's view

This sounds like a worst-case scenario to me, although I have a high regard for Adam Posen.  I do expect the Fed to raise rates at least two more times this year, strengthening the Dollar in the process.  The key for markets is the timing and extent of these moves.

Trump has been successful in jawboning the US Dollar Index down.  However, this will be more difficult when GDP growth picks up and investors see higher US interest rates. 

Precious metals such as gold and silver have recovered recently due to global tensions and a slightly softer US dollar.  Tensions, such as we see with Russia over the latest Syria incident have to be perceived as worsening to remain highly influential.  Otherwise, their impact will be seen quickly as fully discounted. 

An eventual, rapid rise in the US Dollar Index will become a strong headwind for precious metals and also the US stock market, which is currently somewhat overextended and facing an additional reaction and consolidation

Here is a PDF of AEP’s article.