At this stage last year, we were talking about how the Fed might cut rates by around six times in 2024. This time around, we’re talking about how they might not even get to two rate cuts in 2025. As thing stand, traders are pricing in just ~36 bps of rate cuts for next year as seen here.

And among those central banks that are slated to continue cutting interest rates, the Fed is the one that market players are seeing with the highest probability of cutting the least. How the times have changed.

The dollar long con looks to be brought forward. But what has changed?

The biggest thing of course is the US election result. Trump’s win has definitely altered the landscape with threats of large scale tariffs against US trade partners and tax cuts. That has thrown a spanner in the works of the Fed, who are still hoping to get inflation back towards 2%.

The disinflation process has proven to be a bit bumpy also as of late, albeit still largely running its course. However, the muddied outlook now makes it tough to envisage a smooth and clear path back towards the 2% target. Not least with the US consumer still running hot, despite a softening labour market.

So, the real risk for the dollar now ties back to the economy and how Trump’s policies might impact all of that. The outlook now hinges on the notion that Trump will eventually get his way in executing his campaign pledges. And that’s reflected in the more hawkish Fed pricing by markets and arguably also among policymakers at the latest FOMC meeting.

As such, the reaction function suggests that any tail risk that materially leads to a different scenario other than that will be bad for the dollar. That being these few couple of situations:

1. The economy turns out to be much softer in 2025, with labour market slack gathering pace
2. The disinflation process stays the course and resumes a quicker pace again in the new year
3. Trump tariffs are not as forceful and high octane as anticipated, leading to less inflation fears
4. Trump tax cuts hit a bit of a snag and gives markets more time to digest the whole situation

I would argue that right now, emotions are still running high particularly after the latest Fed policy decision. The dot plots and Powell’s remarks suggest a pause in January, which might extend further depending on economic developments.

That’s giving the dollar a tailwind going into the turn of the year. But as we saw with how things played out this year, this sort of tailwind can eventually dissipate and turn the other way around. At some point in the middle of 2024, we were talking about just one rate cut by the Fed for the year as opposed to the six priced in during December 2023.

So, that is pretty much where we’re at. It’s a case of markets having a rough idea of what may transpire in 2025 but nothing is a given. In trading, the journey is just as important as the destination at the end of the day.

This article was written by Justin Low at www.forexlive.com.