The Dollar's Second Wind

Read the Data, Not the Fed Chair

The US dollar surged to its highest levels in over a year in June, as markets began to price in a more hawkish Fed. The market is now fully pricing in at least one rate hike this year.

Meanwhile, expectations for tighter policy elsewhere are fading. ECB officials are now balking at further rate hikes as oil prices have fallen back to pre-war levels, while the yen has hit a 40-year low on concerns the government wants the Bank of Japan to slow down further rate increases. In Canada, soft labour market and core inflation readings have dimmed prospects for rate hikes any time soon.

Front-end rate differentials have moved substantially in favour of the US dollar since May. Ex-ante real rates have increased as well, as rising nominal yields coincided with falling inflation expectations. But can these trends be sustained? Will rates continue to support a stronger dollar?

Many analysts are wasting time trying to determine whether Fed Chair Warsh is genuinely hawkish or merely posturing to boost his credibility. The more important issue is that core inflation forecasts remain stubbornly high, even as energy markets have normalized. The latest concern is about surging chip prices, which have forced firms to hike prices of electronics like smartphones and laptops.

Our rates colleagues believe the Fed will remain on hold this year. But if inflation does not clearly decelerate over the next couple of prints, the Fed would be forced to raise rates as early as September.

We expect the dollar to remain firm over the next few months until the inflation picture becomes clearer. Stronger-than-expected CPI prints would likely drive further gains, while softer readings could trigger some pullback. Even so, a return to the aggressive rate-cut expectations seen earlier this year isn’t in the cards.

Rate differentials are driving the US dollar. Unless US inflation meaningfully softens, the dollar is likely to stay on the front foot in coming months. A sustained depreciation of the US dollar looks more like a 2027 story.

The European Central Bank has long faced criticism for hiking rates in 2008 and 2011 in response to commodity-price spikes that ultimately proved transitory. Unfortunately, its 25bps rate hike in June may one day be viewed in a similar light.

The ECB raised rates by 25bps in June and presented four scenarios that were mainly built around different assumptions for oil prices: mild, baseline, adverse and severe. But crude oil prices have fallen rapidly and are now below even the mild scenario’s assumptions. President Lagarde continues to defend the June decision publicly, but the May and June CPI reports provide little evidence that elevated energy prices are feeding through to the broader inflation basket. Meanwhile, several hawkish members of the Governing Council have notably softened their rhetoric.

We believe the June hike was a one-off and expect the ECB to keep rates unchanged for the rest of this year. In fact, we see roughly a one-in-three chance that President Lagarde revives the familiar “we’re in a good place” language at the July 23 meeting, explicitly signalling a pause.

We remain cautious on the euro’s prospects. In our view, the single currency has undergone three distinct re-ratings since early 2025. The first was in February 2025 on hopes of an economic revival in Germany after Chancellor Merz was elected. The second and third occurred in April 2025 (“Liberation Day”) and January 2026 (Greenland crisis). These were essentially waves of euro buying by European asset managers to reduce their exposure to the US dollar.

However, Germany’s economy continues to disappoint, and the de-dollarization narrative has faded. Consequently, the euro appears vulnerable to a sizable de-rating in coming months.

We’re lowering our expected range for EURUSD to 1.12 to 1.16 for the rest of this year.

TextThe pound continues to struggle under the weight of familiar structural challenges. Andy Burnham is set to become prime minister in late July, but markets have largely taken the impending leadership change in stride.

The central issue remains fiscal credibility. Burnham’s “Manchesterism” agenda may resonate with Labour supporters and local governments, but investors have yet to be convinced that a more active industrial policy and greater public-sector involvement can be reconciled with meaningful fiscal discipline.

Meanwhile, the Bank of England (BoE) continues to strike a cautious tone. Although inflation remains above target, policymakers have increasingly highlighted signs of weakening domestic demand. We continue to believe the BoE’s next move will be a rate cut rather than a hike. More broadly, however, sterling’s challenges are rooted less in monetary policy than in concerns around fiscal credibility. Until confidence in the fiscal outlook improves, or economic growth shows clearer signs of strengthening, we remain cautious on the pound.

We’re maintaining our 2026 forecast for the GBP to fall to 1.30 vs. the USD and to 0.92 vs. the EUR.

Japanese officials continue to threaten intervention, but they face a credibility problem. Intervention can buy time, but without a meaningful shift in the underlying policy mix, it’s losing its effectiveness.

The Takaichi administration may have tolerated a modest rate hike in June, but that does not mean the Bank of Japan has been given a free hand to normalize monetary policy. The government’s draft annual economic blueprint—a key signal of policy priorities—makes clear that monetary policy is expected to support growth and remain closely aligned with broader government objectives.

Moreover, the government’s response to the recent energy crisis—releasing strategic petroleum reserves and a ¥3.1 trillion supplementary budget centred on energy subsidies—shows that this administration prefers to burn through limited buffers rather than take unpopular decisions.

That said, we believe markets may have become excessively bearish on the yen. According to CFTC data, speculative investors are holding record short yen positions. At the same time, ex-ante real yields have improved significantly—albeit remaining negative out to the five-year sector—as inflation expectations have declined. We also expect authorities to resist a disorderly depreciation in the currency, even if they are no longer defending specific exchange-rate levels.

We continue to expect the JPY to fall to 165 vs. the USD in the coming months. However, we believe the balance of risks becomes more supportive for the yen thereafter and continue to forecast a move back to 150 next year.

The Chinese renminbi has appreciated 7% against the US dollar, and 10% in broad trade-weighted terms, over the last 12 months. By the standards of China’s heavily managed exchange rate, this is a substantial advance.

While Chinese authorities previously signalled their preference for a strong currency, partly to boost the renminbi’s international appeal, they have now shifted their guidance. The People’s Bank of China (PBOC) does not disclose its FX intervention, but the persistent rise in FX assets of state-owned banks suggests authorities are now systematically mopping up excess dollar inflows. Market sources indicate that the PBOC has relaxed restrictions on USD deposit rates—allowing large banks to offer higher rates on corporate dollar deposits—to encourage exporters to retain their earnings in US dollars.

These measures form part of a broader effort to push back against further currency appreciation. In our view, the authorities’ primary objective is exchange-rate stability, allowing exporters time to adjust to the renminbi’s earlier gains. At the same time, it would not be out of character for the PBOC to engineer a period of two-way volatility to discourage speculative positioning and reinforce the message that USDCNY is not a one-way bet.

We’re maintaining our forecast for USDCNY to stay around 6.80 by the end of this year and fall to 6.50 next year.

We remain cautious on the Mexican peso.

The currency has traded in a relatively stable 17.0–18.0 range this year and remains popular among emerging-market investors thanks to its attractive real yields.

Beneath the surface, however, there are growing signs that the peso’s strong valuation may be difficult to sustain. In real trade-weighted terms, the currency is at its strongest level since 2008. At the same time, Mexico’s growth outlook has deteriorated considerably. Real GDP growth has averaged barely 1% over the past three years, remittance inflows have stalled, and uncertainty surrounding the future of CUSMA continues to weigh on investor sentiment.

Banxico is likely to hold rates at 6.5% over the next couple of meetings, but we do not believe the easing cycle is over. In our view, the central bank would prefer to move in lockstep with the Fed to avoid destabilizing the peso. But policymakers may ultimately have little choice but to resume easing even if that means diverging from the Fed.

Our analysis suggests that MXN volatility rises significantly when the spread between Mexican and US policy rates falls below 300bps. We expect that threshold to be breached within the next six months, either because the Fed hikes and Banxico does not follow, or because the Fed remains on hold while Banxico resumes rate cuts.

Given the large stock of carry-trade positions in MXN, a clear narrowing in interest-rate differentials could trigger a meaningful depreciation in the currency.

We expect MXN to weaken to 18.0 vs. the USD by the end of this year and to remain stable around those levels next year.