The US Dollar Maintains Strength Amid Economic and Political Support

The US dollar defied widespread expectations of weakening last year, posting a robust appreciation fuelled by US economic outperformance, a hawkish shift in Federal Reserve (Fed) rate expectations, and the Republican victory in the 2024 election. Over the past four years, the US dollar index has climbed more than 20%, including a 7% rise in 2024 that brought it to its highest year-end level in two decades. Early 2025 has seen a continuation of this trend, with the dollar reaching its strongest point since October 2022 last week, supported by strong US economic data and thin market liquidity.

Even before the election, the US economy’s relative strength was pushing traders to reduce expectations for Fed rate cuts, driving up US yields and boosting the dollar. President-elect Donald Trump’s victory and his proposed policies further bolstered the dollar's bullish outlook. Looking ahead, the dollar’s strength is expected to persist into early 2025, supported by a favourable economic environment, fiscal policies, and potential tariffs.

This week, investors will scrutinise the minutes from the Fed’s December policy meeting for insights into the timing of future rate cuts. Key economic data releases, including factory orders, job openings, ISM services figures, and Friday’s jobs report, will also shape market sentiment.

Although no sharp deterioration in the US labour market is anticipated, a gradual weakening could align with the Fed’s cautious approach to easing amid persistent inflation risks, especially those linked to potential tariff policies. While the dollar is likely to strengthen further, the upward trajectory in 2025 is unlikely to be a straightforward or linear one.

The Pound Struggles as Dollar Strength and Economic Concerns Weigh

The pound enjoyed robust strength in the first half of 2024, driven by a more favourable domestic economic environment, diminished political risks, relative yield advantages, and a supportive global risk sentiment. However, these positive factors have been eroding over recent months. In early 2025, GBP/USD has fallen by approximately 1%, reaching nine-month lows near $1.24.

The decline is primarily dollar-driven, as the US currency continues its rally, supported by resilient US economic growth and elevated yields. The pound’s weakness is also tied to the euro, with their correlation increasing amid shared concerns over potential tariffs and rising European gas prices.

Looking ahead, the pound’s trajectory in 2025 will likely hinge on two factors: the Bank of England’s (BoE) approach to monetary policy easing and the persistence of dollar strength. Despite growing UK-specific worries—such as December’s downgraded manufacturing PMI and business sentiment hitting a two-year low—money markets are currently pricing in only about 60 basis points of BoE easing for the year.

This restrained market expectation suggests that while the pound faces headwinds, its outlook will depend heavily on how these economic and policy dynamics evolve.

The Euro Faces Renewed Pressures Amid Economic and Policy Challenges

The euro has started 2025 on a weak note, slipping to its lowest level since November 2022 and breaking below the $1.03 mark against the US dollar. Hedge funds are increasingly betting on further declines, with parity once again in sight for the coming months.

Despite nearing oversold territory, the euro’s outlook remains clouded by a challenging domestic environment. Weak Eurozone economic growth lags behind major peers, including the UK, while risks of US tariffs and a potential energy crisis further strain the region. The last time EUR/USD reached parity was following Russia’s invasion of Ukraine, driven by a spike in gas prices and a deterioration in the Eurozone’s terms of trade. Current conditions echo that period, with gas inventories depleting at their fastest pace since 2021 and cold weather driving up heating fuel demand, raising fears of another energy crisis.

Diverging monetary policy expectations are also pressuring the euro. The widening short-dated swap rate differential reflects the Federal Reserve’s more hawkish stance compared to the European Central Bank (ECB). This week’s focus will be on Eurozone inflation data for December, where a rebound is anticipated. Any significant upside surprise in inflation could challenge market expectations of four ECB rate cuts this year, potentially offering the euro some stabilisation.

For now, however, the euro remains vulnerable to downside risks, weighed down by cyclical, political, and energy-related concerns.