The U.S. Dollar Index (DXY), a benchmark measuring the greenback’s value against six major currencies (euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc), surged over 10% in just three and a half months (from its September 27th low to its January 13th high). On January 13th, the DXY broke through the crucial 110.00 level. While it has slightly retreated since, it remains the top-performing major currency this year.
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Fig 1: US Dollar Index Performance
This impressive rally is attributed to several factors, primarily the widening interest rate differentials between the United States and other major economies, according to Kar Yong Ang, a financial market analyst at Octa Broker. The Federal Reserve (Fed) currently holds its benchmark interest rate between 4.25-4.50%, the second highest among eight industrialized economies.
Fed’s Stance and Geopolitical Factors Bolster Dollar
Crucially, unlike other central banks, the Fed is not anticipated to aggressively cut rates in 2025. This stems from the continued resilience of the U.S. economy, supported by strong labor market data and robust consumer spending. Further amplifying the dollar’s appeal are geopolitical uncertainties and trade war risks, driving safe-haven demand. Donald Trump’s presidential election victory acted as a catalyst for the recent dollar rally.
“Donald Trump’s presidential win was widely expected to boost the U.S. dollar, as his trade and immigration policies were perceived as inflationary. Consequently, the market began pricing in this outcome well in advance, initiating the dollar’s ascent a month before the election,” explains Ang.
Trade Tensions and Currency Impacts
Trump’s explicit threats to impose tariffs on the Eurozone and Canada exerted downward pressure on their respective currencies. The euro, representing 58% of the DXY, has depreciated over 8% against the dollar since September 25th, 2024. Risk-sensitive currencies like the Australian dollar (AUD) and New Zealand dollar (NZD) suffered even greater losses, exceeding 10%.
Fig 2: Major Currencies Performance Since October 2024
Essentially, the dollar’s strength reflects fears of Trump’s policies potentially fueling inflation or triggering a full-blown trade war. Coupled with the outperformance of the U.S. economy compared to its peers, the Fed is likely to maintain a slower pace of monetary policy easing than other nations. A recent Bloomberg survey projects modest 1% growth for the Euro Area this year, marginally exceeding the 0.8% forecast for 2024 but significantly below the 1.4% long-term average.
Diverging Central Bank Policies and Euro Outlook
Market expectations point to three or four 25-basis point rate cuts by the European Central Bank (ECB) in 2025, contrasting with only one or two by the Fed. Under these conditions, a substantial rebound in the EUR/USD from its recent lows seems improbable. “There’s a greater than 50% probability of EUR/USD reaching parity this year, potentially even dipping below 1.0000 temporarily,” comments Ang, highlighting the Eurozone’s structural challenges, including high energy costs, deindustrialization, geopolitical tensions, and fiscal instability.
Dollar Rally Showing Signs of Fatigue
However, the DXY’s rally appears to be losing momentum. A bearish divergence has emerged between the DXY price and the Relative Strength Index (RSI). Fundamentally, many bullish factors are already priced in, leaving bulls lacking fresh impetus for further gains. “The market may have overestimated dollar-related positives, with the greenback potentially overvalued currently. Betting on continued appreciation carries risk,” cautions Ang. The market might be pricing in a less probable scenario – the imposition of sweeping tariffs by Trump and subsequent destabilization of global trade.
Potential for Market Reversal
While this scenario remains possible, its likelihood is relatively low. Bloomberg reported that the U.S. might opt for a more gradual approach to tariffs. “Markets are forward-looking. Having anticipated Trump’s victory before the election, they may now begin to discount underlying bullish expectations and anticipate a downturn, following a classic ‘buy the rumor, sell the news’ pattern,” concludes Ang.
