Fed rate cuts loom, but dollar’s long game looks stronger than most expect

Capital Economics has trimmed its near-term U.S. dollar rebound expectations, anticipating the Federal Reserve will resume rate cuts, with markets pricing in 150 basis points of easing. However, the firm maintains a more optimistic long-term outlook than many, projecting dollar stabilization due to a resilient U.S. economy, upside risks from AI investment, persistent inflation limiting rapid Fed easing, and favorable interest rate differentials compared to Europe and Asia. While a deeper U.S. slowdown or political risks pose downside threats, the dollar, despite a roughly 10% decline this year, remains above its long-term average on a real trade-weighted basis.

Analysis

Capital Economics has revised its near-term forecast for the U.S. dollar, no longer expecting a significant rebound this year due to the Federal Reserve's anticipated resumption of rate cuts. Markets are currently pricing in approximately 150 basis points of easing over the next year, a notable increase from the 100 basis points expected in July. Despite this, the firm projects the dollar will stabilize rather than fall substantially, arguing that the extent of Fed easing is already discounted. This outlook is supported by a resilient U.S. economy, upside risks to growth from the ongoing surge in AI investment, and persistent inflation that is likely to prevent the Fed from cutting rates too rapidly. Furthermore, the analysis posits that interest rate differentials will continue to favor the dollar, as other major central banks in Europe and Asia are expected to pursue less aggressive easing policies. Key risks to this stable outlook include a more severe U.S. slowdown or recession, which could trigger looser-than-priced Fed policy and weaken the dollar against the euro and yen. Even after a roughly 10% decline this year, the dollar remains above its long-term average on a real trade-weighted basis, with some overvaluation noted, particularly against Asian currencies.

Key Decisions for Investors

• Investors should consider trimming aggressive short-dollar positions, as the analysis suggests the currency is more likely to stabilize than decline sharply, with much of the anticipated Fed easing already priced in.
• Closely monitor U.S. growth and inflation data, as a severe economic slowdown represents the key downside risk that could force more aggressive Fed cuts and weaken the dollar, particularly against the euro and yen.
• For long-term positioning, recognize that the U.S.-centric AI boom, exemplified by high-performing stocks like SMCI and APP, may provide structural support for the dollar through sustained capital inflows, warranting strategic long exposure if U.S. growth continues to outpace global peers.
• In currency pair selection, consider that any potential dollar depreciation may be more concentrated against some Asian currencies, while it could retain relative strength against European currencies due to a more favorable growth and interest rate outlook.