The dollar and geopolitics — either a correction or a large-scale reversal

[Ben Graham]

On Saturday, US President Trump announced the introduction of an additional 10% tariff on goods from eight European countries, including Germany and the United Kingdom, effective February 1. If no agreement on Greenland is reached by February 1, tariffs will be increased to 25% by June 1. There is no official White House statement yet; only Trump's announcement on social media.

In essence, we are now witnessing a scenario that, until recently, seemed completely impossible: a trade war with the United States' closest allies — which appeared to have been settled last summer — has resumed in a much harsher form.

Once again, Trump is making a strange and unpredictable maneuver that raises global tensions and, among other things, disturbs currency balances. Europe agreed to US tariff demands in July last year, but the new escalation could trigger another instrument the EU previously hesitated to use — restrictions on investment. If such a decision is taken and Macron immediately announces the need to implement it, the configuration of cross-border capital flows between Europe and the US will shift to the dollar's detriment.

While European countries are still formulating their response, let us look at what macroeconomic indicators are saying. Three factors that matter for the currency market, in one way or another, increase the probability of a stronger dollar.

The yield on 5-year TIPS has been rising rapidly from the low reached on December 26. Since the end of November, the market has been confident that the Fed would cut rates more aggressively than previously thought, which led to a rapid weakening of the dollar across the currency spectrum; however, over the last three weeks, the opposite dynamics have emerged. It is still weakly expressed, but it seems reasonable to assume that inflation may resume rising in January — that is, the delayed effect from the introduction of higher tariffs will finally begin to hit the consumer market.

Treasury Secretary Scott Bessent said on Sunday that the Supreme Court is unlikely to overturn the tariffs imposed by President Donald Trump under the International Emergency Economic Powers Act, because such a cancellation would mean undoing Trump's entire economic program. Bessent thus supported Trump in his bid to "buy Greenland," demonstrating administration unity on the issue. The Supreme Court decision could come as early as this week, and if it is favorable for Trump, the dollar will most likely respond with strength.

Also note the change in rate expectations. Whereas on December 29, the market saw two rate cuts — in April and July — as of Monday morning, the nearest cut has been pushed to June, and the second to December or even January 2027. In other words, the market's view of Fed policy has become more hawkish.

It is also important that the market reacted essentially in the opposite way than might be expected to the accusations directed at Fed Chair Powell. Trump is pressing hard for faster rate cuts and increasing pressure on Board members to achieve his goal, yet the market has largely ignored his moves and, moreover, is tilting toward the opposite scenario of slower cuts. This is undoubtedly bullish for the dollar.

Finally, note changes in speculative positioning on the futures market. According to the CFTC report published on Friday, the aggregate short position on the US dollar was reduced by $9.3 billion during the reporting week to -$2.7 billion — effectively almost eliminated; the yen and the euro suffered the most.

Thus, one must assume that market sentiment is gradually shifting in favor of a stronger dollar. Macroeconomic indicators do not provide grounds for a confident reversal of expectations, but geopolitics so far appears to dominate the risk balance. Hence, the hypothesis that the dollar may accelerate its strengthening in the short term, but there are not yet grounds for a larger-scale move.

The material has been provided by InstaForex Company - www.instaforex.com