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Dollar to rally if the market flips to betting on Fed hikes.
The U.S. dollar could be set for meaningful gains amid a looming market regime shift in Federal Reserve interest rate expectations.
"The most interesting regime shift for markets and macro traders will be if the market starts to price in Fed rate hikes. This will light a fire under the USD and FX and bond market volatility," says Brent Donnelly, analyst at Spectra Markets.
"Is it time to get long USD? I think so," says Donnelly. "I think EURUSD is best: U.S. stocks outperforming and U.S. economy substantially outperforming Europe. And now maybe, just maybe, the market is going to start pricing Fed hikes."
Markets had previously priced a gradual Fed easing cycle through 2026, although the inflationary shock posed by the war in the Middle East has seen the market shift to expecting no change in rates.
The inflationary issue is acute: data out Tuesday showed U.S. inflation accelerated again in April, with headline CPI rising to around 3.8% year-on-year, driven largely by surging energy prices linked to the Iran conflict and disruption through the Strait of Hormuz, which has tightened global oil supply and pushed fuel costs higher.
However, core inflation surprised to the upside at 2.8%, confirming it to be truly stuck above the Fed’s 2% target.
Core inflation is generated domestically, meaning it can be limited by higher rates at the Federal Reserve.
"This data only includes the first signs of broader spillover from the oil price shock into core components, and annual inflation is set to move higher in May," says Katherine Judge, an economist at CIBC Capital Markets.
The direction of travel in Fed rate bets is clear. Image: Goldman Sachs.
Fed Governor Austan Goolsbee said this week that "we have an inflation problem in this country," a clear signal that the Fed's interest rate-setting committee cannot ignore the problem for much longer.
"Rate rises are now firmly back on the table as policymakers look to contain a price spiral that is starting to take hold," says Isaac Stell, Investment Manager at Wealth Club.
The dollar has steadily retreated over recent months as investors move to price in rate cuts at the Federal Reserve while they simultaneously see ex-U.S. central banks raising rates.
For example, bets of up to three rate hikes at the ECB have helped the euro-dollar exchange rate steadily higher through 2025 and into 2026.
However, if the Fed also raises rates, the euro's recent interest rate advantage is challenged.
"We are on the front edge here of pricing Fed hikes. The numbers are tiny but we are certainly on the hike side of zero now," says Donnelly.
