The US dollar is holding firm as traders adjust interest rate expectations in Europe and the UK and remain cautious over geopolitical risks, according to Commerzbank economist Michael Pfister.
The greenback had rallied during the height of the Middle East conflict, but much of that initial surge has faded as markets factor in changing economic data, central bank signals and evolving political tensions. Even so, Pfister noted the dollar has not yet returned to its prewar levels.
European rate outlook flips from cuts to hikes
Pfister said traders have sharply revised their outlook for the European Central Bank (ECB) and the Bank of England (BoE), moving from a narrative of multiple rate cuts to the prospect of rate hikes later this year.
Current market pricing points to:
- around two rate increases by the ECB before year-end
- at least one hike by the BoE over the same period
This shift reflects a reassessment driven by stubborn inflation rather than growth optimism.
Inflation and energy costs drive repricing
The recalibration in expectations follows an earlier oil price shock tied to the Middle East conflict, which pushed up energy costs and complicated plans for looser monetary policy.
In the euro area:
- the final March reading of the Harmonised Index of Consumer Prices (HICP) was revised up to 2.6% year-on-year
- this exceeded initial estimates and was heavily influenced by a 5.1% jump in energy prices
Pfister argued that this renewed inflation pressure has forced markets to abandon the assumption of near-term ECB rate cuts and instead price a tighter path.
In the UK, where the Bank Rate stands at 3.75%, traders have also moved away from anticipating imminent policy easing, responding to similarly persistent inflation dynamics.
US inflation and labor data complicate Fed outlook
In the United States, the macro picture presents a different mix of challenges:
- headline inflation rose to 3.3% year-on-year in March, the highest since May 2024
- the increase was driven largely by a 12.5% surge in energy costs
- core inflation, excluding food and energy, climbed to a more moderate 2.6%
The labor market remains tight. Initial jobless claims for the week ending April 11 fell to 207,000, reinforcing the case against quick rate cuts.
Futures markets now imply a roughly 99.5% probability that the Federal Reserve will keep rates unchanged at its next meeting, reflecting the ongoing tension between elevated headline inflation and slightly more contained core pressures.
Geopolitics still a key driver for dollar
Pfister highlighted that the recent ceasefire in the Middle East has provided limited relief for markets but has not fully unwound the earlier risk premium.
He said a more pronounced correction in the dollar and related risk assets could occur if:
- hostilities in the region end decisively, and
- shipping through the Strait of Hormuz normalizes
For now, geopolitical attention has started to spread to other regional flashpoints, while domestic US political focus has turned toward Federal Reserve policy and its impact on growth and inflation.
Volatility drops to low levels, opening hedging window
Pfister noted that implied volatility in currency markets has fallen back to unusually low levels. This is mirrored more broadly in market gauges such as the Cboe Volatility Index (VIX), which is trading near 18.60, well below recent peaks.
Low implied volatility means the cost of buying protection against sharp price moves, for example via options, is relatively subdued. Pfister suggested that many market participants may see this as an attractive moment to hedge dollar exposure.
Positioning and risk reversals still uncertain
Although the dollar’s earlier gains have largely cooled, Pfister stressed that uncertainty around risk reversals remains elevated. The currency has not fully retraced to pre-conflict levels, and market pricing still reflects a degree of residual risk premium.
He argued that those expecting:
- a gradual return to calmer market conditions, and
- a continuation of low volatility
might find current dollar levels appealing for building protective positions.
Scope for strategic hedging
With volatility compressed and geopolitical risks unresolved, Pfister indicated that the coming weeks may offer a tactical window:
- traders exposed to sharp currency swings can secure hedges at lower cost
- defensive strategies can help guard against a sudden rebound in volatility or a renewed leg higher in the dollar
Such a reversal could be triggered by renewed tensions in ceasefire negotiations, fresh disruptions to energy supply routes, or another upside surprise in inflation data that forces central banks into more aggressive tightening.
In this environment, Pfister sees the combination of higher-for-longer rate expectations, lingering geopolitical risk and low implied volatility as broadly supportive for the dollar, even as the currency trades off its peak levels.
Curious how macro trends like rate expectations shape crypto? Explore their impact in our guide on fiscal policy and crypto markets.
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