The USD Rally May Run Out of Gas

The US dollar’s recent rally is likely to fade into year-end as energy and bond-market stress eases and the Federal Reserve underdelivers relative to current pricing.

• Since the July 29 Fed meeting, markets have priced 75 basis points of additional hikes by December 2027, while the DXY is testing resistance at 102; stabilization in energy markets or no Fed hike in October could reverse some dollar gains.
• The euro faces wider fiscal and political risks: the Bund-OAT spread has exceeded 105 basis points, the highest since the 2011–12 European debt crisis, although EURUSD is expected to remain within 1.12–1.15 this year.
• The Canadian dollar’s decline from USDCAD 1.380 to 1.415 reflects a roughly 150-basis-point widening in two-year US-Canada swap rates; Desjardins nevertheless forecasts USDCAD at 1.39 year-end and 1.35 next year.
• Sterling remains vulnerable because the UK imports roughly 44% of its energy, government debt is 105% of GDP, gas is above USD25/mmbtu and 10-year gilt yields have risen to 5.4%; GBPUSD is forecast at 1.35 year-end.
• Yen intervention of about USD175 billion, or 15% of Japan’s foreign-exchange reserves, has not changed USDJPY’s broad range of 164–152; faster Bank of Japan tightening is needed for a move toward 150 next year, while CNY is forecast at 6.70 against the dollar this year and 6.50 next year.

Takeaway: Investors should not assume that the current dollar strength marks a new bull market; a normalization of energy prices and narrower rate differentials would favor a partial reversal, although geopolitical, fiscal and trade risks could keep currency volatility high.