What are the prospects for the dollar? The distribution of risks for the USD is asymmetric.

The dollar's outlook in the coming weeks and months will remain heavily dependent on the Federal Reserve's revised narrative. The baseline scenario remains rate cuts in September and December, seen as a way to reduce political tensions through moderate easing. In this context, Jerome Powell's softer tone in Jackson Hole is more of a confirmation of his previously announced strategy than a new beginning..

To create room for cuts, the Fed is more emphasizing downside risks to economic activity and the labor market. At the same time, the sustainability of the pro-inflationary stimulus from tariffs remains uncertain, limiting the willingness to make clear statements. Hence, communication focuses on the balance of risks rather than a firm rate path.

In such an environment, the distribution of risks for the USD is asymmetric. If growth and employment remain robust and the tariffs' impact on prices proves transitory, the Fed could scale back the cuts from what the market is pricing in and tone down its dovish signals.This would support dollar strengthening by upwardly revising the expected rate path and closing short positions.

Fed signals readiness to cut rates

Still, scenarios leading to a weaker dollar hold the upper hand. Weaker data—such as lower durable goods orders—would solidify or increase expectations for deeper easing, including discussions of 50-basis-point moves. A shift in interest rate valuations would reduce the relative attractiveness of dollar-denominated assets compared to other markets.

There is also a less intuitive variant: real activity remains relatively strong, while inflation (e.g. PCE) and, above all, inflation expectations are rebounding, while the Fed's message continues to signal a willingness to cut. This configuration raises questions about the coherence of the central bank's reaction function and typically results in an increase in the currency risk premium, which negatively impacts the dollar—as seen, among other things, in the path of the Turkish lira during periods of reduced monetary policy credibility.

The conclusions remain challenging for advocates of sustained USD strength. The Fed's room for maneuver is limited and exchange rate volatility is elevatedIt's difficult to predict a quick, lasting return of the dollar to its former advantage, also for structural reasons: from the heated debate over the Fed's independence (including echoes of the Lisa Cook case) to the prospect of a deterioration in the US fiscal position in light of the new administration's plans. In such a scenario, positive surprises for the dollar are possible, but they will most likely be temporary and result from adjustments to interest rate expectations.

Source: OANDA TMS Brokers