Dollar at Risk as Fed Tightening Cycle Looms

Markets are bracing for what is shaping up to be a significant tightening cycle from the Federal Reserve, with expectations of four hikes by June next year. This would represent a stark turnaround from earlier this year, when markets were still pricing multiple rate cuts.

The dollar's performance has varied sharply across previous tightening cycles, and history suggests that tighter Fed policy does not always guarantee dollar strength. In fact, the US 2-year yield has typically continued to rise after the first hike in a cycle, while DXY has weakened on several occasions.

Two notable historical examples are 1994 and 1999, when the Fed began tightening policy from levels much closer to neutral than the emergency settings seen in 2004, 2015, and 2022. In both cycles, the 2-year yield continued to move higher after the first hike, yet DXY initially went the other way.

Heading into the start of this likely tightening cycle, the technical picture has started to improve, with recent gains in energy prices helping drag Treasury yields and the dollar higher. However, while the current relationship between front-end US rates and DXY is unusually tight, it would be highly presumptive to assume it will simply persist if the Fed does begin tightening.