Morgan Stanley expects the dollar rally to be short-lived, as the US-Europe interest rate differential is likely to narrow, and fears of Iran conflict could drag down the economy.

Why does AI · Morgan Stanley see the future of the dollar as bearish?

Source: Global Market Report

Morgan Stanley expects the dollar to weaken as the interest rate differential between the US and Europe narrows, and the Iran conflict may harm the US economy.

Since the US and Israel jointly attacked Iran on February 28, the dollar has continued to strengthen. This rally has benefited from the dollar’s safe-haven status and the US’s position as the world’s largest energy producer.

Since the outbreak of the Iran conflict, the Bloomberg US Dollar Index has risen 2% and reached its highest level since December last year on Monday. Meanwhile, the euro and yen have both fallen more than 2% during the conflict, as Europe and Japan rely heavily on Middle Eastern energy supplies.

In a report released on Wednesday, Morgan Stanley strategists led by David Adams wrote that the dollar reaching this level is more likely a “bull trap,” as the market has already priced in inflation risks from rising energy prices but underestimated the negative impact on economic growth.

According to the latest data from the Commodity Futures Trading Commission (CFTC), as of the week ending March 17, dollar-related futures positions have turned net long for the first time this year.

Rising energy prices have heightened inflation risks and prompted traders to factor in the Federal Reserve’s rate hike expectations; before the war, the market was betting on a rate cut by the Fed.

Morgan Stanley strategists say that stagflation risks put central banks in a difficult position, forcing policymakers to make trade-offs, which could lead to different policy outcomes.

Morgan Stanley believes the Federal Reserve may overlook “temporary inflation shocks” and focus on growth, expecting two rate cuts this year, while the European Central Bank is expected to hike rates by 0.5 percentage points to combat inflation.

The strategists state: “Whether in absolute terms or relative to market pricing, the direction of interest rates may be unfavorable for the dollar.”