The dark days for dollar appear to have no end in sight amid unconvincing attempts at mounting a recovery, but Capital Economics believes the greenback is poised to prosper for the rest of the year as tariff uncertainty fades and interest rate differentials swing in the favor of the U.S.

“We still expect the dollar to recover some ground over the rest of 2025 as interest rate differentials shift back in favour of the US and some of the policy uncertainty discount evident in the dollar since the 2nd April ‘Liberation Day’ event continues to fade,” Capital Economics said in a recent note.

The dollar’s weakness earlier in the year reflects more than just typical economic cycles. It stems from a rapid reassessment of the U.S. economic and financial outlook amid unusually volatile policy shifts and trade tensions. But with tariff uncertainties settling and the Federal Reserve expected to maintain its policy rate, the usual relationship between interest rate differentials and exchange rates is set to reassert itself, underpinning a dollar rebound.

The Trump administration’s unconventional policy approach has dented confidence in the U.S. as a safe haven and introduced some uncertainty premium into the dollar’s valuation, Capital Economics said. But market participants have "become desensitised to the administration’s rhetoric, given that actual policy has typically proven less radical than implied by initial press reports and White House announcements," Capital Economics added.

Looking ahead, the fading of tariff-related uncertainties alongside sustained U.S. economic strength and stock market outperformance could support the greenback’s modest recovery in the months to come. 

The Federal Open Market Committee (FOMC) may also have a role to play in coaxing the dollar out of the doldrums as Capital Economics doubts that the FOMC will cut rates as deep as markets expect as tariff-induced inflation limits the cutting cycle.

"We continue to expect a tariff-induced rebound in price pressure to keep policymakers hesitant to ease too far," Capital Economics said. But other major central banks - aside from the BoJ will deliver policy
"broadly in line with what money markets discount, or take a somewhat more dovish stance," it added, meaning that "interest rate differentials move in favour of the greenback over the coming months."

The caveats to expectations for a limiting cutting cycle would be a more serious slowdown in the US economy or a more modest rise in inflation than expected, most likely resulting in "a more dovish FOMC stance than we have factored in," Capital Economics said. This would prompt the Fed into deeper cuts, forcing the dollar to back paddle. 

Cited from: Investings.com