Dollar stronger due to consensus

The consensus in financial markets is overwhelmingly in favour of a weaker dollar due to the upcoming Fed interest rate cuts. While interest rates in the United States are falling, they are rising in countries such as the United Kingdom, France, and Japan. However, in the latter three countries, this is not due to economic strength, but instead to economic and political weakness. This development suggests that the current consensus on a weakening dollar may prove to be just as wrong as the widespread predictions of a US recession in 2022.

DXY

The DXY (Dollar Index) is a weighted index that measures the value of the US dollar against a basket of six major currencies: the euro (57.6% weighting), Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%) and Swiss franc (3.6%). The index has a base value of 100 as of March 1973 and is widely used by traders, investors, and central bankers to assess the overall strength or weakness of the dollar. A rising DXY means that the dollar is strengthening against these currencies, while a falling DXY indicates a weakening dollar.

Relative interest rate movements

If the Federal Reserve cuts interest rates while other central banks do not, the dollar is likely to weaken. That seems logical, but the underlying reasons for interest rate movements are at least as important as the movements themselves.

In the United Kingdom, the rise in government bond yields to their highest level since 1998 illustrates this dynamic.

30-year gilt yields

Keir Starmer’s government is struggling with a budget deficit of around £35 billion, while traditional buyers of government bonds, such as pension funds, are withdrawing en masse. This is not a sign of economic strength that justifies higher interest rates, but of weakness that is forcing investors to demand a higher risk premium.

France is in a similar position, although the symptoms appear less acute. French government bond markets are exhibiting increased volatility, with risk premiums gradually rising relative to German Bunds and now comparable to those in Italy. President Macron’s government has so far managed to calm the situation, but the underlying fiscal situation remains fragile. Political divisions are hampering structural reforms, keeping debt dynamics under pressure.

Japanese government bond yields

Holdings in the super-long tail of the JGB curve have traditionally been dominated by domestic life insurance companies, which now appear to have limited capacity to absorb additional duration risk. As a result, there has been lukewarm demand from Japanese insurers for longer maturities recently. This is despite super-long JGBs being traded at their cheapest levels since their introduction in 1999.

Japan is experiencing upward pressure on interest rates from a different dynamic. After years of extremely accommodative policy, the Bank of Japan is being forced to gradually raise interest rates to support the weak yen and combat rising inflationary pressure. However, these interest rate hikes are not driven by economic strength, but by the need to restore monetary stability after years of ultra-low interest rate policy have put the yen under extreme pressure. Here too, we are not seeing interest rate rises driven by strength, but forced adjustments driven by weakness.

America’s structural advantages

While other developed economies struggle with structural challenges, the United States benefits from unique advantages that extend beyond the current economic cycle. American labour productivity has dramatically outperformed that of other G7 countries by about 30% since 2000, according to available data.

Investments in artificial intelligence and digital infrastructure further reinforce this productivity gap. Recent data show a veritable investment boom in data centres and digital infrastructure, providing powerful growth impulses to the economy. These investments are not merely cyclical in nature but form the basis for sustained productivity growth.

Trump’s trade policy is also contributing structurally to a stronger dollar. For most trade agreements, the US has set up asymmetric tariff structures: steep barriers to imports, while American exports to most markets remain largely tariff-free. This asymmetry is gradually reducing the US trade deficit – data show that the deficit has already more than halved, partly due to companies anticipating tariffs.

Positioning dollar futures

The Federal Reserve’s ultimate goal

The market consensus expects about six interest rate cuts by the Federal Reserve, which would bring the policy rate to 3% by the end of 2026. However, this expectation seems overly optimistic and ignores fundamental economic realities. The natural or neutral interest rate for the US economy is likely to be around 3.5-4%, based on 1.5-2% real growth plus 2% inflation. With AI-driven productivity growth accelerating, real growth could even exceed 2%, implying a higher neutral interest rate.

Moreover, the Atlanta Fed’s GDPNow projections now show 3.9% annualised growth for the current quarter. These figures are above potential growth and do not exactly point to a major slowdown that would justify aggressive Fed easing.

Historically, extreme positioning out of the dollar has often been a contrarian indicator. When all the major players move in the same direction, vulnerability to unexpected developments arises. For example, the Federal Reserve may turn out to be less dovish than expected, or economic data may be better than forecast.

US dollar versus euro

Europe’s temporary upturn in perspective

Although Europe’s economic performance this year has been better than expected – contributing to dollar weakness – this must be placed in historical perspective. Since 2015, US growth has been on average around 100 basis points per year higher than that of the eurozone and 200 basis points higher than Japan.

The ECB implemented interest rate cuts earlier and more aggressively than the Fed in 2024, which helped stabilise eurozone activity. Additionally, the growing prospect of an end to the Russia-Ukraine war also helped improve business and consumer confidence in Europe. However, these factors are largely cyclical and temporary in nature.

Structure trumps cycle

A scenario of simultaneous US economic weakness and a revival in the rest of the world, which would be necessary for a major cyclical decline in the dollar, therefore seems highly unlikely. The structural advantages of the US economy, combined with the forced interest rate hikes elsewhere driven by weakness rather than strength, suggest that the dollar will prove more resilient than the current consensus expects.

Investors who blindly rely on consensus expectations of dollar weakness risk once again being on the wrong side of the market – just like those who were certain of a US recession in 2022 that never materialised. The story of 2025 is unlikely to be the predicted dollar crisis, but rather a reaffirmation of US economic supremacy against increasing vulnerability elsewhere.