War rewrites the forex script, with the dollar rebounding strongly to its best performance in nearly eight months

As the conflict in the Middle East disrupts Wall Street’s existing judgments on the global dominant reserve currency, the U.S. dollar is poised to record its best monthly performance since July of last year.

As of now, the dollar index has accumulated an increase of about 2.4% in March, marking its best monthly performance since July 2025, mainly supported by inflows of safe-haven funds, war-driven increases in energy prices, and a market adjustment of expectations for interest rate cuts by the Federal Reserve.

Thanks to the strength in March, the dollar index has risen 1.7% year-to-date, after a significant drop of 9.4% last year.

This marks a clear reversal in the dollar’s trend. Just before the outbreak of the conflict, the dollar had recorded its fourth consecutive month of decline. As the fighting continues, this shift is putting pressure on banks and investors who were previously bearish on the dollar.

For instance, strategists at JPMorgan have turned bullish for the first time in a year. In the futures market, speculators have also shifted to betting on the dollar’s rise, whereas in mid-February, their bearish sentiment towards the dollar was at its highest level in about five years.

Steven Englander, head of G10 FX research at Standard Chartered Bank, stated, “The dollar short positions at the beginning of 2026 were caught off guard.”

As traders close their short positions and energy prices remain high, Englander maintains his prediction for further dollar appreciation, a view he has held since early 2026.

He anticipates that by the end of this year, the dollar-to-euro exchange rate will rise to around 1.12 dollars (meaning 1 euro equals 1.12 dollars), which would be the strongest level since May of last year, while the current exchange rate is approximately 1.15 dollars.

Pessimistic Expectations at the Beginning of the Year

Institutions such as Goldman Sachs and Deutsche Bank had predicted at the beginning of the year that the dollar would weaken, partly due to expectations that the Federal Reserve would continue to ease monetary policy in 2026.

The Federal Reserve had implemented three interest rate cuts in the second half of last year, totaling 75 basis points. The market originally anticipated that policymakers would continue to pursue easing this year.

However, with the ongoing war in Iran, the closure of the Strait of Hormuz leading to higher prices for crude oil and other commodities, investors have now leaned towards the view that the Federal Reserve will resume raising interest rates in the face of rising inflation.

Previously, the trade war initiated by President Trump last year also sparked speculation in the market about potential capital outflows from U.S. assets. However, it has been shown that investors are still continuously flowing in while hedging against the risk of a dollar decline.

A deeper risk is that this war may reignite discussions about long-term “de-dollarization.” Whether due to concerns about Trump administration policies or due to the war’s impact on fiscal prospects.

For decades, the dollar’s core position in the global financial system has been unmatched. However, Deutsche Bank’s report released this week points out that the war is testing the dollar’s status as the global currency for oil transactions and mentions the potential for increased use of the renminbi for settlements in the future.

Growth Concerns May Become a Key Variable

The more immediate concern is whether the market will shift its focus to economic growth risks if energy prices remain high for an extended period. Although the U.S. is relatively more resilient as an oil-producing country, once growth concerns intensify, market expectations for Federal Reserve interest rate cuts may re-emerge.

Goldman Sachs strategists wrote this week that if the market turns to concerns about growth, “the overall appreciation of the dollar against G10 currencies may be suppressed.” Morgan Stanley goes further, suggesting that as economic concerns escalate, the dollar will ultimately weaken.

Predictions on Hold

Due to the uncertainty surrounding the duration and trajectory of the war (whether it escalates or reaches a peace agreement), many institutions have paused updating their predictions.

Jayati Bharadwaj, head of foreign exchange strategy at TD Securities, stated in a report this week that in the current high-risk environment, the dollar should benefit; if the conflict escalates, the firm may shift to a bullish stance on the dollar.

However, she remains reluctant to adjust her long-term bearish forecast for the dollar, as there is still room for the dollar to weaken if a peace agreement between the U.S. and Iran is reached in the coming weeks.

Bharadwaj wrote, “In that scenario, the ‘exceptionalism’ of the U.S. economy would diminish, risk premiums would decline, and the recent ‘Hedge America’ trades triggered by U.S. policies would all put pressure on the dollar.”

Erica Camilleri, senior global macro analyst at Manulife Investment Management, also holds a bearish view on the dollar, although the firm has already closed its dollar short positions this month.

Camilleri pointed out that the market’s pessimism regarding economic growth outside the U.S. is “overblown,” while the Federal Reserve may still cut rates, and she believes that other central banks will not take similar actions this year.

She stated, “We still tend to think that the dollar will depreciate in the medium term and expect the euro to appreciate by the end of the year.”

Bulls Currently Hold the Upper Hand

However, for now, bulls still dominate. On Friday, amidst growing concerns about a prolonged war, both the dollar and oil prices rose. Despite Trump announcing another delay in targeting Iranian energy facilities on Thursday, market sentiment did not improve.

In the options market, bullish bets on the dollar dominate for the next month, but longer-term positions indicate that the market expects the dollar’s strength to gradually weaken.

Elias Haddad, head of global market strategy at Brown Brothers Harriman, noted, “The relative importance of the global macro environment has given way to war-related news.”

“This is a tactical market,” Haddad said. “You must react quickly.”

(Source: CaiLianShe)