Unpacking a Puzzling Dollar Decline

The US dollar index fell yesterday, struggling to hold above its 50-day moving average and an upward-sloping trendline that has been in place for several months. The dollar weakened against most major currencies, except for the traditional safe havens—the Japanese yen and Swiss franc. This decline was somewhat surprising given the risk aversion in equity markets amid fresh US tariffs and cautious rhetoric from the Federal Reserve, which pushed US yields higher across the curve.

Signs of Tariff Fatigue in FX
US President Donald Trump signed a proclamation to reinstate a 25% tariff on steel and aluminium imports, effective from 12 March. The European Union vowed to retaliate, raising the prospect of an escalating trade dispute between transatlantic allies. The EU may act swiftly by reintroducing duties it first imposed on the US during Trump’s previous term. Tariff risks remain significant, as evidenced by recurring headlines, yet currency markets took the latest developments in their stride, with risk-sensitive FX gaining ground against the dollar.

A review of macroeconomic data does not fully explain the dollar’s decline either. Admittedly, sentiment among small-business owners in the US dipped slightly in January from December’s six-year high, largely due to uncertainty over tariffs and their potential impact on growth and inflation. However, business owners remain largely optimistic about deregulation and tax policies, with 77% believing it is a good time to expand and 47% expecting improved business conditions ahead.

Monetary Policy Rhetoric
Cleveland Fed President Hammack indicated a preference for keeping interest rates steady for the foreseeable future, while Fed Chair Powell reinforced the message of patience on rate cuts during his semi-annual monetary policy testimony to the Senate. Markets remained unfazed, continuing to price in just one additional Fed cut this year.

Perhaps investors are wary that US economic growth could slow due to tariffs, inflation, and tight monetary policy. Alternatively, the dollar’s valuation may simply be stretched. Bullish positioning on the greenback is crowded, and as we have previously argued, with trade risks and the Fed’s pause already priced in, the dollar likely requires evidence of an even stronger US economic backdrop or a sharp deterioration in global risk sentiment to advance significantly.

Euro Searching for Clarity Amid Uncertainty
Market positioning on the euro is approaching levels last seen during the initial wave of the pandemic in 2020. The single currency faces multiple headwinds, ranging from weak Eurozone cyclical dynamics and dovish monetary policy to political and geopolitical risks, particularly in light of Trump’s tariff threats. Rising natural gas prices are another concern.

European gas reserves are being depleted at their fastest rate since the 2022 energy crisis due to a combination of cold weather and declining Russian gas imports. Seasonal price spreads also made it uneconomical to replenish stocks during the summer. As a result, some EU nations have fallen short of their storage targets, and with the bloc’s reserves standing at around 50% capacity in early February—well below the roughly 70% recorded last year—concerns over future supply have triggered a surge in gas prices to fresh two-year highs. This is negative for the euro and supportive of the dollar, adding further downward pressure on EUR/USD.

Since the US election, the correlation between US and euro area interest rates has weakened significantly, reflecting diverging expectations for growth and inflation between the two regions. This widening rate differential is another drag on EUR/USD.

Political uncertainty in Europe could also be a source of volatility, although markets appear relatively relaxed about the upcoming German election. Two-week options on the euro, which encompass the election period, imply a potential 1.5% move in EUR/USD in either direction. From the current spot price, this would still leave EUR/USD above $1.01, but given the array of risks facing the euro, a move towards parity remains a possibility. For now, the weaker dollar is allowing EUR/USD to push above $1.03, with its 50-day moving average in sight around $1.04, though the move may prove short-lived.

That said, several factors could offer support for the euro. A softer tariff outcome, a Ukraine-Russia ceasefire, looser fiscal policy in Germany, a cyclical rebound in China, or a downturn in the US economy could all act as catalysts for a more meaningful euro recovery.

Sterling Records Best Day in Two Weeks
The pound ended a three-day losing streak against the US dollar on Tuesday, recording its best daily performance (+0.6%) in over two weeks, thanks to broad-based dollar weakness. However, sterling also gained against a range of other currencies, notably against safe-haven peers such as the Japanese yen (+1.0%) and Swiss franc (+0.9%), as well as higher-beta currencies like the Norwegian krone and Australian dollar. This suggests that a modest paring of Bank of England (BoE) easing expectations may have also played a role in supporting the pound.

BoE policymaker and noted hawk, Catherine Mann, clarified yesterday why she advocated for a 50-basis-point cut last week. She emphasised that this was not a signal for immediate further cuts but rather an attempt to “cut through the noise” and enhance communication with global markets. She also highlighted the need for continued restrictive monetary policy to tackle persistent inflation. Recent survey data suggests that wage disinflation is expected over the course of the year, though inflation expectations remain elevated and above levels consistent with the BoE’s 2% target.

As a result, traders scaled back expectations for BoE rate cuts this year, now pricing in 60 basis points of easing, down from 66bps at the start of the week. Looking ahead, key economic data releases early tomorrow—including GDP estimates for December, preliminary Q4 growth figures, and industrial and manufacturing output for December—will be closely watched by sterling traders, following today’s US CPI report.