MUFG: Dollar Consolidation Expected at Weaker Levels in Early 2026

Dollar Weakness and 2026 Outlook

• 📉 The dollar experienced its worst annual decline since 2017, with most of the weakness occurring in the first half of the year, followed by greater stability in the second half.
• ⚠️ Key headwinds driving the dollar weaker in 2025, such as heightened US policy uncertainty and the Fed resuming its rate cut cycle, are expected to persist into 2026.
• 🎯 MUFG's view is that Eurodollar will drift back above the 1.20 level over time, though risks suggest the dollar might consolidate at weaker levels in the first half of 2026.

Federal Reserve Policy and Yield Differentials

• 🏦 The Fed indicated a preference to pause the rate cut cycle at the start of 2026, potentially skipping the January meeting.
• 📊 Confidence remains that the Fed will deliver at least two to three more cuts in 2026 if the labor market remains weak.
• ⚖️ If the Fed continues cutting rates while other central banks like the ECB hold steady, the yield differential should favor a weaker dollar in 2026.

Policy Uncertainty and Market Volatility

• 📈 Concerns about potential policy flash points like tariffs or deregulation in 2025 did not significantly disrupt equity markets, though the dollar dipped.
• 🎢 Volatility returned to year-to-date lows by the end of 2025, creating a supportive environment for investors to take on more risk and favor carry strategies in FX markets.
• ⚠️ A significant downside risk for the dollar is the potential for a new Fed chair, appointed under the Trump administration, to implement a much faster pace of rate cuts, leading to sharper dollar weakening.

The Japanese Yen and Intervention Risks

• 💴 Businesses in Japan are urging the government to address the yen's weakness, which inflates import costs and burdens households and businesses.
• 🗣️ The risk of intervention by Tokyo to support the yen is considered very high, given recent verbal interventions by Japanese officials.
• 📉 The yen remained weak at the end of 2025 despite the BOJ hiking rates, diverging from normal fundamental drivers and coinciding with speculative short yen positions reaching their highest levels since mid-2024, increasing the likelihood of intervention.