The dollar's breakout above its year-long trading range has reactivated positioning momentum, with IMM long-USD exposure still well below early-year peaks, leaving room for further near-term accumulation. Options flow is signalling stronger conviction for USD gains against the euro than the yen. The sharp reversal in Brent, which has now fully unwound its conflict-driven rally, is compressing European rate expectations and widening the transatlantic yield spread, the primary mechanical driver of the current move. EUR/USD is at risk of slipping further below 1.1000 if the Fed follows through on rate hike rhetoric, though the base case for a recovery into the 1.1400 to 1.1800 range remains intact.
MUFG says the dollar is set for a second straight weekly gain after the Fed's hawkish shift and collapsing energy prices widened the policy gap with Europe, though it expects USD strength to fade by year-end.
Summary:
- The dollar index has broken above its year-long trading range and is approaching levels last seen before the Liberation Day tariff announcement in early April 2025, according to MUFG's weekly FX note
- New Fed Chair Kevin Warsh's inflation rhetoric at his first FOMC meeting has fuelled expectations for multiple rate hikes, lifting US yields even as energy prices fell sharply following the US-Iran Strait of Hormuz agreement, per the note
- Brent crude has fully reversed all gains recorded during the conflict, a move MUFG describes as faster and larger than expected, with implications for the inflation outlook in Asia and Europe
- NY Fed President John Williams said current policy is well-positioned to return inflation to target, forecasting a decline to around 3.5% by year-end and 2.0% by 2028, but acknowledged inflation remains elevated, per his public remarks cited in the note
- ECB Chief Economist Philip Lane signalled a final 25bp hike remains possible, noting the upper end of the ECB's estimated neutral rate range has risen to 2.50%, according to MUFG's account of his comments
- MUFG maintains a long USD/NOK trade recommendation and expects the ECB's annual Sintra forum next week to shed further light on the transatlantic policy divergence
The US dollar is on track for a second consecutive week of gains, driven by a hawkish pivot from the Federal Reserve and a dramatic collapse in energy prices that has widened the monetary policy gap between the United States and Europe, according to analysis from MUFG.
The dollar index has broken above the top of its year-long trading range and is closing in on levels last traded before President Trump's Liberation Day tariff announcement in early April 2025, around 103.00. MUFG notes that a full recovery to those levels would signal that the risk premium tied to US policy uncertainty, which had weighed heavily on the currency through the first quarter, has been largely unwound.
Central to the move is the stance of new Fed Chair Kevin Warsh, whose tough inflation rhetoric at his inaugural FOMC meeting rattled markets and stoked expectations that the central bank could deliver a series of rate hikes. US yields have risen accordingly, even as Brent crude has fully reversed all of the gains accumulated during the US-Iran conflict, a sell-off MUFG describes as faster and larger than most had anticipated.
The bank argues that a smaller and shorter-lived energy price shock would be a net positive for Asia and Europe, the regions most heavily exposed to the disruption in the first half of the year. Improving growth momentum outside the United States, combined with the Fed ultimately staying on hold, underpins MUFG's base case that the dollar's current strength will not persist through year-end.
New York Fed President John Williams reinforced that cautious outlook, stating that the current policy stance is well-positioned to bring inflation back to the 2% target on a sustained basis. He projected inflation easing to around 3.5% by year-end before gradually declining toward target in 2028. His relatively steady tone contrasts with Warsh's reluctance to provide forward guidance, a divergence MUFG flags as a potential source of increased volatility in US rates and the dollar.
On the European side, markets have scaled back tightening expectations in response to lower energy prices, pulling European yields lower and reinforcing the policy divergence narrative. ECB Chief Economist Philip Lane has kept a final 25 basis point hike on the table, noting that the upper bound of the ECB's estimated neutral rate range has moved up to 2.50% and that forward-looking indicators still point to inflationary pressures ahead. MUFG maintains its forecast for a September hike but acknowledges the risk of the ECB holding, which would add to near-term headwinds for the euro.
The bank sets out two scenarios for EUR/USD. In the base case, where the Fed does not follow through on rate hike signals, the pair is expected to recover into the 1.1400 to 1.1800 range. If the Fed does tighten materially, EUR/USD could fall further below 1.1000 and the dollar index could extend gains by a further 3 to 5%. MUFG says the ECB's annual policy forum in Sintra next week will be a key moment for gauging how far the two central banks' paths are likely to diverge.
