As expected, the U.S. Federal Reserve raised its federal funds target rate by 25 basis points this week to 2 percent. What was less expected was the Fed's announcement that there will be a total of four rate hikes this year, which means that two more are to come in 2018. Previously, it was unclear whether there would be three or four total rate hikes this year.

So how did the U.S. dollar perform given this news? The answer is, it depends.

Against the major currencies, the dollar really did not move that much. However against the emerging market (EM) currencies, the dollar has strengthened, signaling that the higher U.S. interest rates are starting to put some strain on the EM currencies.

EM countries typically run a current account deficit so they rely on foreign capital inflow to fund those deficits. In order to attract that foreign capital inflow, they offer high interest rates. When U.S. interest rates were low, the so-called 'carry trade' (the practice of investors borrowing cheap U.S. capital and investing it in these higher-yielding currencies) supported the EM world.

Last year, the weak dollar also helped those EM economies. But as the interest rate differential between the dollar and emerging market currencies narrows, the latter become less attractive, discouraging investors from taking on the investment risk. With increasing currency volatilities in emerging markets, that is sending capital back into the dollar.

This poses a threat to the EM countries. Their economies grow by leveraging, but not only is that foreign money not coming in, their foreign borrowing levels - primarily denominated in U.S. dollars - are surging as a result of the stronger dollar and higher U.S. interest rates.

To illustrate this phenomenon, since the beginning of this year, the Argentine peso has fallen by about 30 percent, the Turkish lira by 20 percent and the Brazilian real by 11 percent. The South African rand and Russian ruble seem equally vulnerable going ahead.

My View: One currency that has not been affected continues to be the Chinese yuan. With China's GDP now surpassing the U.S. as the No. 1 economic power in the world, it is hard to label China an EM country, but on a per capita GDP basis is still is. Given its ongoing, quasi-fixed exchange rate regime and strong capital controls, however, the Chinese economy has not been affected as much as other EM countries. President Trump said that he will confront China “very strongly" over trade in the coming weeks. While his goal is improving the U.S.-China trade imbalance, if he negotiates on currency policy as well, the other EM countries may not object.

For more City National commentary, subscribe to our newsletters.

If we can help you with any Foreign Exchange needs, please email foreignexchange@cnb.com or call (800) 447 4133.

The information in this report was compiled by the staff at City National Bank from data and sources believed to be reliable but City National Bank makes no representation as to the accuracy or completeness of the information. The opinions expressed, together with any estimate or projection given, constitute the judgment of the author as of the date of the report. City National Bank has no obligation to update, modify or amend this report or to otherwise notify a reader in the event any information stated, opinion expressed, matter discussed, estimate or projection changes or is determined to be inaccurate. This report is intended to be a source of general information. It is not to be construed as an offer, or solicitation of an offer, to buy or sell any financial instrument. It should not be relied upon as specific investment advice directed to the reader’s specific investment objectives. Any financial instrument discussed in this report may not be suitable for the reader. Each reader must make his or her own investment decision, using an independent advisor if prudent, based on his or her own investment objective and financial situation. Prices and availability of financial instruments are subject to change without notice. Financial instruments denominated in a foreign currency are subject to exchange rate risk in addition to the risk of the investment. City National Bank (and its clients or associated persons) may, at times, engage in transactions in a manner inconsistent with this report and, with respect to particular securities and financial instruments discussed, may buy from or sell to clients or others on a principal basis. Past performance is not necessarily an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.