Dollar Holds Firm as US Rates Outlook Still Dominates

By Rae Wee and Greta Rosen Fondahn

SINGAPORE (Reuters) -The dollar defended its recent dominance on Tuesday in a holiday-lined week, as investors considered the prospect of higher-for-longer U.S. interest rates, leaving other major currencies struggling near milestone lows.

The U.S. dollar has leaped ahead over the past three months against a basket of currencies, fuelled by diverging central bank outlooks.

After its policy meeting on Wednesday, the U.S. Federal Reserve now looks set to hold rates higher for longer than markets had expected, elevating U.S. Treasury yields and sending the currency 1.2% up to two-year peaks.

Trading volumes are likely to thin out this week as the year-end approaches, and major economic data releases are scarce, meaning the rates theme is likely to remain the main driver of moves in the foreign exchange market.

The dollar index held up firm on the day, 0.1% higher at 108.2, still hovering close to the two-year high of 108.54 it reached on Friday.

Other currencies took a breather on Tuesday, but the impact of the dollar’s recent rally was still felt across the board.

The euro was last bought at $1.0393, slightly lower on the day and not far from November’s two-year low, while sterling hovered around a one-month low at $1.2532.

Elsewhere, the yen was pinned near a five-month low and last stood at 157.04 per dollar, having already fallen close to 5% this month into territory that is keeping traders on alert to any intervention from Japanese authorities.

The Bank of Japan (BOJ) last week kept rates on hold and stayed vague on when it could next raise them. The central bank communication stood in stark contrast to the Federal Reserve’s hawkish tone a day earlier, when it projected a measured pace of rate cuts in 2025, sending the yen sliding.

“The shifts in Fed-BOJ policy divergence are now more likely to weaken the JPY,” said Vishnu Varathan, head of macro research for Asia ex-Japan at Mizuho Bank.

“JPY carry trades could, in defiance of a step-up in volatility or uncertainty, remain in play as two critical factors – supported ‘carry returns’ and mitigated capital risks of JPY squeeze – conspire favourably.”

Down Under, the Australian dollar eased 0.19% to $0.6237, while the New Zealand dollar dipped 0.16% to $0.5641.

The Reserve Bank of Australia (RBA) released the minutes of its December policy meeting on Tuesday, which signalled the central bank was closer to cutting interest rates, but needed the flow of economic news to support its confidence that inflation was slowing.

DOLLAR AHEAD

The greenback looked set to end the year more than 6% higher, after falling back last year.

While a benign U.S. inflation reading on Friday eased concerns about the pace of Fed cuts next year, markets are still pricing in just about 35 basis points worth of easing for 2025, in turn underpinning the dollar.

“Our base case is that the dollar will make some further headway next year as the U.S. continues to outperform, the interest rate gap between the U.S. and other G10 economies widens a little further, and the Trump administration brings in higher U.S. tariffs,” said Jonas Goltermann, deputy chief markets economist at Capital Economics.

Ahead of U.S. President-elect Donald Trump’s return to the White House in January, global central banks have urged caution over their rate paths due to uncertainty on how Trump’s planned tariffs, lower taxes and immigration curbs might affect policy.

Goldman Sachs said it was uncertain how tariffs could affect future Fed policy, adding that the inflation impact of price increases should fade after a year.

“The 2018-2019 trade war tightened financial conditions by enough to prompt an easing in Fed policy,” Goldman Sachs added.

“Much about the current cycle is different, but the 2018-2019 experience shows that the monetary policy risks from tariffs are at a minimum two-sided.”

(Reporting by Rae Wee and Greta Rosen Fondahn,Editing by Shri Navaratnam and Ed Osmond)