Since 2026, the dollar, which should have strengthened significantly, has actually been relatively flat, supported by a combination of solid economic growth, strong stock market performance and safe-haven demand from the war in Iran. However, this situation could turn around as interest rate expectations change.
Markets have recently reassessed the Fed’s policy path. Federal funds rate futures and the bond market suggest that investors are increasingly inclined to believe that there will be no rate cuts in 2026, and that there is even the possibility of a rate hike. The probability of at least a 25 basis point rate hike this year has risen to more than 30% from near zero two weeks ago after oil prices rose due to the war in Iran, pushing inflation to a three-year high.
Interest rates staying high for an extended period of time usually favors the U.S. dollar because higher yields attract overseas flows into U.S. assets such as Treasuries and money-market instruments, and those allocations first require buying dollars, which pushes up the exchange rate.
But the foreign exchange market did not fully accept this logic before. Bank of America G10 foreign exchange strategy director Alex Cohen (Alex Cohen) pointed out that the dollar’s performance is limited, the key reason is that the market is not enough Fed rate hike expectations. He said: “The lack of expectations for a Fed rate hike seems to be weighing on the dollar. The energy-induced global inflation shock has repriced the interest rate paths of other G10 central banks, but FX markets remain reluctant to significantly account for a Fed hike.”