The start of 2025 has been marked by a significant surge in the US dollar, with the dollar index breaching the 110 threshold on January 13 for the first time since November 2022. Although there has been a recent pullback, the overall upward trajectory of the dollar has remained intact, stabilizing around 109. This trend has prompted analysts to scrutinize the underlying factors driving the dollar’s strength.

Since September 2024, when the Federal Reserve embarked on a new cycle of interest rate cuts, the dollar index surprisingly entered an upward channel, defying conventional expectations that typically link rate cuts to a weaker dollarFactors contributing to the resilience of the dollar include a robust performance of the US economy and widening interest rate differentials between the US and other major economiesThese dynamics have been pivotal even amidst expectations of monetary easing.

However, the landscape appears to be shifting

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Market participants are increasingly focusing their attention on inflation ratesIn December 2024, the Federal Open Market Committee (FOMC) decided to lower interest rates by 25 basis points, a move that was largely anticipatedNevertheless, the projections for future cuts were significantly downgradedThe latest dot plot suggests the Fed is now anticipating two rate cuts in 2025—considerably fewer than the previously forecasted four cutsThis realignment of expectations has led to a dual sell-off in both US stocks and bonds, amplifying uncertainties about the economic outlook.

The pivotal question now is whether the Federal Reserve will continue on this path of reducing interest ratesThe consensus in the financial markets seems to lean toward a slowing pace of rate cuts, implying that US dollar and Treasury yields are likely to remain elevatedKey to the Fed’s decision-making process will be forthcoming inflation data.

Recently, strong employment data has further complicated the narrative

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Following the release of impressive job growth figures for December, Wall Street’s projections for rate cuts were revised downwardEconomists are now speculating that the Fed’s next move could be an interest rate hike instead of a cutLast month, the US economy added 256,000 jobs, and the unemployment rate dipped, prompting Economic Outlook Group’s chief global economist Bernard Baumohl to remark, “The economy is entering the new year with quite a bit of momentum.”

This week’s two inflation reports have added further tension to market sentimentsThe December Producer Price Index (PPI) showed a mild increase, leading to a slight depreciation of the dollarFollowing this, the Consumer Price Index (CPI) data was released, which reported a year-over-year increase of 2.9% in DecemberThis was in line with expectations, while the month-over-month increase of 0.4% was marginally above forecasts

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However, perhaps most notably, the core CPI saw a reduction to 3.2%, marking the first decline in six months which was below both expectations and the previous figure.

The unexpected cooling of core CPI ignited a wave of optimism in the market, prompting traders to shift their expectations for the Fed’s first rate cut from September to JulyCumulative rate cuts for the year were adjusted upward from 28 to 40 basis points, essentially reverting to levels seen prior to the non-farm payrolls data release.

Nonetheless, industry insiders caution that if the Fed contemplates further cuts, more tangible progress on inflation will be necessaryThe stickiness of inflation should not be underestimated, as upward risks still loom over the US inflation landscape, compelling the Fed to tread carefully in its monetary policy decisionsMaintaining the status quo could see inflation push Treasury yields higher, which in turn would influence dollar valuations.

The upcoming challenges for the Federal Reserve will also stem from the ascent of a new administration

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This administration’s policies, which favor tax cuts, increased tariffs, immigration controls, and deregulation in the Wall Street and energy sectors, may contribute to job market resilience but at the same time escalate inflation levels in the USIt’s evident that the theme of “inflation trading” is poised to dominate market activities over the coming months.

As investors navigate the unpredictability of US economic policy and its potential ramifications on the global economy, uncertainty is driving US Treasury yields higher and bolstering the dollar's strength.

Goldman Sachs, in its annual foreign exchange market outlook, anticipates that the dollar is entering a phase characterized by “greater strength and durability.” As global economic dynamics and policy environments evolve, the firm projects that “strong dollar” will become the prevailing theme in the forex market in 2025, with this trend likely to sustain for an extended period.

This robust performance of the dollar has concurrently placed considerable pressure on non-dollar currencies, which have experienced widespread declines

On January 13, as the dollar index passed the 110 mark, currencies such as the euro, pound sterling, and South Korean won fell correspondingly, with some even dipping to multi-year lowsFor instance, the euro-to-dollar exchange rate hit a low of 1.0178, marking the lowest level since November 2022, while the pound followed suit, dipping below the 1.21 mark for the first time since November 2023.

Notably, forecasts from UBS’s FX Outlook for 2025 suggest that anticipated interest rate cuts from the European Central Bank, potential tariff actions from the US, and political uncertainties in France may weigh heavily on the euro, possibly dragging the euro-dollar exchange rate below parity this year.

Goldman Sachs also predicts that the euro will fall to 0.97 against the dollar within six months, down from a previous forecast of 1.05. Simultaneously, the firm has revised its pound-to-dollar forecast down to 1.22, from an earlier estimate of 1.32.