US Dollar’s Reign: A Story of Strength, Tariffs, and Potential Reversal
The US dollar continues its dominant ascent, reaching heights unseen since late 2022. Driven by robust US economic performance and lingering tariff concerns impacting global rivals, the greenback’s surge has captivated financial markets. Experts at UBS anticipate this "stronger for longer" trend to persist, fueled by a combination of solid domestic data and mounting uncertainties elsewhere. The dollar index (DXY), a benchmark measuring the dollar against a basket of major currencies, soared above the 110 mark, reflecting a near 9% appreciation since late September. This remarkable rally underscores the dollar’s resilience and the comparative vulnerabilities of other economies.
The American economy’s outperformance has been a cornerstone of the dollar’s strength. Positive surprises in nonfarm payrolls and the services sector purchasing managers’ index (PMI) have painted a picture of sustained economic vitality, prompting a reassessment of Federal Reserve rate cut expectations. Fewer anticipated cuts translate to higher US yields, rendering dollar-denominated assets more attractive to investors and bolstering demand for the currency. In contrast, Europe faces a more subdued economic outlook, while China, though projected to experience accelerated growth, grapples with the looming threat of US tariffs. This divergence in economic fortunes has further accentuated the dollar’s appeal.
The potential for diverging monetary policies between the US and other major economies adds another layer to the dollar’s upward trajectory. While the Federal Reserve is expected to implement a modest 50 basis points of rate cuts in the coming quarters, the European Central Bank is projected to enact more aggressive easing, with 100 basis points of cuts anticipated in the first half of the year. This policy divergence, according to UBS strategists, acts as a powerful catalyst for currency movements, often leading to trending markets and the potential for exchange rate overshooting. The anticipated difference in policy approach reinforces the attractiveness of dollar-denominated assets and contributes to sustained upward pressure on the greenback.
Beyond the solid macroeconomic backdrop, UBS highlights the underappreciated risk of tariffs in current dollar valuations. While the recent rally has largely been attributed to robust US economic data, the potential introduction of new tariffs presents a significant upside risk to the dollar. The firm suggests that if materialized, these tariffs could propel the DXY into a 110-115 range, with substantial implications for other major currency pairs. This scenario underscores the sensitivity of currency markets to trade tensions and the potential for tariffs to amplify existing dollar strength. The euro, British pound, and Swiss franc could all experience significant depreciation against a tariff-boosted dollar.
However, UBS anticipates a potential turning point in 2025. While the first half of the year is expected to continue the narrative of dollar dominance, the second half could witness a reversal of fortune. The current positioning of the USD, characterized by significant overvaluation and the highest level of dollar net length since 2015, suggests a potential correction is brewing. This extreme positioning creates vulnerability to a shift in market sentiment or any unexpected economic developments. As the year progresses, factors such as narrowing interest rate differentials and a potential easing of trade tensions could contribute to a weakening of the dollar.
UBS forecasts for the EUR/USD pair reflect this anticipated trajectory, with the pair projected to trade at parity in March, followed by a modest recovery to 1.02 in June, and a more substantial rebound to 1.06 by December 2025. This forecast suggests a gradual erosion of dollar strength against the euro as the year unfolds. Regarding China, despite the potential for dramatically higher effective tariffs, the Chinese yuan (CNY) has only partially priced in this risk, according to UBS, which maintains its forecast for the USD/CNY to reach 7.50 by June. This suggests that further depreciation of the yuan against the dollar is anticipated, albeit at a more measured pace. Overall, the long-term outlook for the dollar presents a complex picture, with continued strength expected in the near term, followed by a potential reversal as market dynamics evolve and global economic conditions shift.
