Synopsis:

Morgan Stanley forecasts the USD Index (DXY) to peak in the coming weeks as risk premiums gradually compress. While tariffs on Europe and China sustain elevated premiums for certain currencies, a broader decline in US rates and fading fiscal expansion fears will drive the USD into a bearish regime, albeit with limited downside.

Key Points:

• Peak in DXY: The USD Index is expected to peak soon as risk premiums tied to policy uncertainty begin to decline with greater clarity on the administration’s preferences.
• Tariff Impact: Tariffs on Europe and China are likely, keeping risk premiums elevated for EUR and CNY. Other currencies may see reduced risk premiums once tariff uncertainties are resolved.
• Rates Dynamics:
  • US rates are projected to peak by year-end and then decline significantly as fiscal expansion risks appear overestimated.
  • The Fed is expected to continue cutting rates at a faster pace than currently priced by markets.
• USD Bear Regime:
  • Falling real rates in a stable risk environment typically herald broad USD weakness.
  • Risk-sensitive currencies gain, while funders like JPY benefit from their inverse relationship with real rates.
  • Historical USD bear regimes have seen the DXY fall ~1.25% per month, but this time the downside is likely limited.
• Constraints on USD Weakness:
  • Weak fundamentals and trade tensions constrain EUR and CNY, reducing the scope for USD downside.

Conclusion:

The USD is nearing a peak, with a bearish regime expected to emerge as US rates fall and risk premiums normalize. However, structural challenges for major counterparts like EUR and CNY are likely to cap USD weakness, limiting the extent of DXY declines