Is the dollar rally unsustainable? Wall Street sounds the alarm on the "bull trap"

In recent days, the U.S. dollar has been showing strong momentum. First, escalating geopolitical tensions have triggered a wave of safe-haven demand. Second, the market has begun repricing the Federal Reserve’s monetary-policy path. However, just as the market seems to have grown accustomed to the narrative of a strong dollar, strategists on Wall Street are starting to warn about the risks behind it.

Since the U.S.-Iran conflict began on February 28, the global foreign-exchange market landscape has been completely rewritten. The dollar has continued to strengthen on the back of its safe-haven characteristics and its status as the currency of the world’s largest energy producer. The U.S. Dollar Index, which tracks the dollar’s performance against a basket of currencies, is up about 2% since the outbreak of the conflict and has touched its highest level since December of last year this week Monday.

However, even as bulls celebrate, several top Wall Street investment banks have issued warnings in unison: this dollar “feast,” which appears unstoppable, may be approaching a turning point.

On March 25, Morgan Stanley said the current rally looks more like a “bull trap.” Goldman Sachs warned that the market’s focus is shifting to a critical point, and Barclays also said that over the next few months, as conditions in the Middle East stabilize and energy prices fall back, the dollar will face an unavoidable period of near-term weakness.

Safe-haven tailwind

Over the past more than three weeks, the primary reason the dollar has been able to show such strong momentum is without a doubt the safe-haven wave triggered by escalating geopolitical conflicts.

As a global core safe-haven currency, the dollar has continued to attract capital inflows during periods when risk events occur frequently. This trend has been further reinforced as the U.S.-Iran conflict has intensified.

Yao Yuan, senior investment strategy advisor at Orient Asset Management’s investment research institute for Asia, pointed out that in the short term, geopolitical conflicts and the energy-price shocks they cause are the dominant drivers of global “risk-off” trades. In this environment, investors tend to “take profits” and convert their portfolios into cash. To pull funds back under the shadow of war, investors sell down all assets, and the buying demand in the market mainly benefits the dollar—especially cash.

At the same time, the United States, as the world’s largest energy producer, has further amplified the dollar’s appeal in this conflict. When Brent crude pushed above $100 per barrel, economies that traditionally rely heavily on Middle East energy imports—such as the euro area and Japan—were hit hard, and their currencies all fell by more than 2% during the conflict. But for the United States, the surge in energy prices does not constitute the same deterioration in trade conditions; instead, it further solidifies the dollar’s relative advantage, due to the突出 of America’s energy independence. Analysts noted that for every 10% increase in oil prices, the dollar typically appreciates by about 0.5% to 1% versus major currencies such as the euro and the pound sterling.

Another key factor supporting this round of dollar strength is the market’s repricing of the Federal Reserve’s monetary-policy path. Before the conflict broke out, the market broadly expected the Fed to enter a rate-cut cycle. However, the spike in energy prices has aggravated inflation risks and completely disrupted that expectation.

At its March policy meeting, the Federal Reserve decided to keep interest rates unchanged in the 3.50% to 3.75% range, while raising its inflation expectations for 2026. The dot plot shows that within the year, only one rate cut is expected. Fed Chair Jerome Powell also released a more hawkish signal, making it clear that the committee would not consider rate cuts until inflation improves further, and even indicating that discussion has begun about the possibility of additional rate hikes. As Joseph Capurso, head of international economics at the Commonwealth Bank of Australia, put it: “If markets begin to price in a new tightening cycle in the United States, the dollar would strengthen significantly against all currencies.”

The foundation of the rally is shifting

However, just as the market seems to have gotten used to the narrative of a strong dollar, strategists on Wall Street are beginning to watch for the risks behind it.

In a report published on March 25, Morgan Stanley said the dollar’s current uptrend is difficult to sustain and looks more like a “bull trap” that lures investors in—using price action to entice investors to enter, only to abruptly reverse afterward.

They believe the market has already fully priced in the inflation risks stemming from rising energy prices, but it has seriously “underestimated the negative impact on growth.”

At the core of Morgan Stanley’s view is a reinterpretation of policy divergence between the U.S. and Europe. The bank’s strategists believe that when weighing the two opposing pressures of inflation and growth, the Fed and the European Central Bank will make markedly different choices. They expect the Fed may ignore “temporary inflation shocks” and shift its policy focus to supporting growth, which would mean two rate cuts within the year. In Europe, because the energy shock directly exacerbates imported inflation, the strategists expect the European Central Bank to be forced to raise rates by 50 basis points in order to “address inflation.”

Morgan Stanley emphasized: “Whether from absolute figures or from relative market pricing, the rate path could be unfavorable for the dollar.” As the U.S.-Europe interest-rate spread gradually narrows, an important pillar that previously supported dollar strength—interest-rate advantage—is now being reversed.

In a report dated March 24, Goldman Sachs FX strategist Isabela Rosenberg wrote: “Even though the market has largely priced the oil-price shock as an inflation and trade-variable factor, if the focus shifts toward greater downside growth risks, it could curb the broad appreciation of the dollar versus G-10 currencies.” Rosenberg noted that extending the conflict would severely damage Europe’s and Asia’s economic and currency growth outlooks. And once markets begin to worry about a global economic growth slowdown, the pace of the dollar’s rise will be disrupted. In Goldman’s view, the dollar may still be able to keep strengthening versus G-10 currencies, but “it is unlikely that the dollar can maintain the same surge pace seen in March.”

Barclays Bank, meanwhile, revealed the dollar’s weakness from a more technical angle. The bank observed that even though geopolitical conflict and the surge in oil prices should logically support the dollar, the dollar’s actual rise—especially versus the euro—has been below the theoretical level that would be implied by the widening of the real interest-rate differential between the U.S. and Europe. Barclays attributed this phenomenon to the stagnation of “dollar premium.”

So-called “dollar premium” refers to the extra return investors demand for the special risks they face from holding dollar-denominated assets—such as unpredictable policy changes in the United States. The report said that since the last U.S. administration introduced broad tariff-policy disruptions to the market, this premium level has changed little. About a 5% premium has been maintained for nearly 12 months, far longer than historical norms.

Barclays’ team said bluntly: “Investors taking long positions in the dollar face an unpredictable risk at any time that the White House’s social media will issue negative commentary on the dollar.” This means that while investors bear U.S.-specific policy uncertainty, they have not received commensurate risk compensation—this “misalignment between risk and return” is limiting further upside for the dollar.

Barclays believes that this dollar rebound driven by geopolitical conditions may be a “bitter victory.” Once the situation eases, the dollar will face downward pressure.

Reporter Li Xizi

Text editor Cheng Hui