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Interview

Why the US Dollar Could Continue to Strengthen

Goldman SachsBrian Dunne, Chris Hussey
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Dollar Strength Drivers

  • Three primary factors are driving the current dollar strength:
    • The conflict between the U.S. and Iran.
    • Sustained U.S. exceptionalism, characterized by dominant AI companies and strong corporate earnings.
    • A potential Federal Reserve shift toward a more hawkish policy path focused on price stability rather than acknowledging growth downside risks.
  • The labor market remains very strong, supporting the Fed's hawkish pivot.

Federal Reserve Policy and Market Pricing

  • Federal Open Market Committee (FOMC) "dot plot" data shows a significant shift:
    • In March, no committee members projected a rate hike.
    • In June, nine members projected at least one hike (potentially more).
  • Market pricing currently reflects:
    • Approximately 6–7 basis points priced in for a July hike.
    • More than one full rate hike priced in by the end of the year.
  • Desk analysis suggests the distribution of outcomes favoring a more hawkish Fed remains underpriced by the market.
  • Chair Powell's comments at a conference in Sintra were perceived as slightly less hawkish than his initial press conference remarks.

Dollar Value Drivers and Global Context

  • Material dollar appreciation requires one of two conditions:
    • A hawkish shift from the Federal Reserve.
    • A more dovish shift or weaker growth outlook for the rest of the world (e.g., European Central Bank or Bank of Japan).
  • Geopolitical risk premiums are currently reduced:
    • Fear regarding rate hikes due to U.S.-Iran conflict has almost completely been priced out.
  • Real interest rate differentials (stripping out inflation) still point toward dollar appreciation by year-end.
  • U.S. exceptionalism faces structural challenges but remains robust:
    • Reserve diversification is continuing over time but has not accelerated as expected.
    • Concerns that Iran might denominate Strait of Hormuz transport fees in Chinese Yuan rather than USD have not yet materialized.
    • Supplanting the USD as the global reserve currency is not currently on the radar in the near term.

Japanese Yen Outlook

  • Japanese government bond yields are at 30-to-40-year highs, yet the Bank of Japan is still viewed as pursuing easy monetary policy relative to inflation.
  • Recent yield increases in the back end of the curve are driven primarily by inflation expectations rather than monetary policy shifts.
  • Current house view:
    • Yen pressure remains weakening in the absence of more hawkish fiscal or monetary policies from the Japanese government.
    • The yen is at its weakest level in decades.
  • Potential catalyst for Yen appreciation:
    • A shift in Japanese pension investment policy from dollar-focused to domestically focused investments.

Strategic Trade Recommendations

  • Primary Trade: Long USD against G10 currencies, specifically favoring the Swiss Franc (CHF).
  • Carry Trade Rationale:
    • Targeting 3% to 4% annualized carry long USD versus CHF.
    • Strategy assumes the dollar will settle in despite volatility, supported by favorable real interest rate differentials.
  • Forward-Looking Tails (Next 3–6 Months):
    • Upside risk: Re-escalation of U.S.-Iran conflict driving energy prices higher.
    • Upside risk: Fed signaling multiple rate hikes or a full hiking cycle by year-end.
  • Specific Instrument Strategies:
    • USD/CHF: Utilizing call spreads to express bullish views; targeting 7–8x payout for year-end call spreads.
    • USD/CNH: Buying one-year USD call options with strikes above 7.0; Chinese Yuan is currently within the sub-10th percentile of the last five years.
  • Emerging Markets: Bullish on carry opportunities in specific EM currencies, notably Brazil and Egypt.