Dollar’s Deadlock Why Policy Uncertainty is Fuelling a Global FX Recalibration

After months of volatility and directional uncertainty, the FX market heads into June still contending with the same structural challenges that have been building for over a year now only with sharper edges. The US dollar, which found some footing in May after a brutal -7.6% decline across March and April, remains on shaky ground. Despite a marginal rebound against the yen, it’s clear that broader investor sentiment is still leaning bearish. That’s not just about rate differentials anymore it’s about confidence in the US policy direction.

The renewed confusion over Washington’s trade stance is creating a cloud that hangs over the dollar’s outlook. Tariffs on steel and aluminium are set to double in early June, and rhetoric toward China continues to harden, especially with new restrictions targeting tech exports and student visas. All of this is likely to weigh on business investment decisions through the summer, even if it hasn’t yet shown up meaningfully in hard data. What’s more, Trump’s so-called “Big Beautiful Bill” is making its way through Congress. If passed in its current form, it could tack on another $3.5 trillion to the US debt profile over the next decade. With global investors already cautious on Treasuries, the idea of taxing foreign holders of US assets under Section 899 is the kind of trigger that could accelerate capital flight, or at the very least widen the chasm of uncertainty around the long end of the curve. It’s no surprise that Moody’s downgrade of the US sovereign rating didn’t cause panic, but it certainly didn’t go unnoticed either.

Markets have largely priced out the possibility of a soft landing, and Fed officials themselves now admit that the chance of a recession is almost as high as their baseline forecast of avoiding one. Yet the Fed remains cautious, potentially behind the curve again. The delay in rate cuts could force a heavier response later, which MUFG now sees as four 25bps cuts in the second half of 2025 more aggressive than prior expectations. If labour market data deteriorates more clearly, and with continuing claims already pushing higher, it’s hard to see the Fed sticking to its current passive stance for much longer. Add to that the legal battle around reciprocal tariffs currently under review by the Supreme Court and the dollar seems ripe for further pressure in H2.

Across the Atlantic, the euro has managed to hold most of its recent gains. Despite a likely ECB rate cut this month perhaps even the first of several EUR/USD has remained supported by a broader rotation out of the dollar. The energy price backdrop has improved markedly since March, and President Lagarde’s comments about the euro’s reserve currency potential hint at an institutional ambition that could quietly reshape portfolio flows over time. If global reserve managers are actively reconsidering their USD exposures, the euro stands as a natural alternative, especially now that negative rates are behind us. That said, the common currency isn’t immune to trade risks. Trump is openly mulling a 50% tariff on EU imports, and with negotiations dragging, the July 9th deadline for reciprocal suspension looms large. Even so, unless that upper-bound tariff is realized, the euro appears poised to absorb the pressure, especially with European bond markets offering relative stability.

Sterling has been the surprise outperformer, rallying to levels not seen since the pre-Brexit era. A partial explanation lies in the optics: the US-UK trade agreement was modest in content but significant in symbolism. It gave the UK a seat at the table while other partners face stalled negotiations. Better-than-expected UK growth in Q1, resilient consumption, and a robust rebound in business sentiment have combined to paint a rosier economic picture than the BoE had feared. Inflation, particularly in services, remains sticky, complicating the MPC’s path forward. May’s rate cut passed with a divided vote, and market pricing around August has turned more cautious. If the pound keeps rising and the UK economy avoids a sharp deceleration, the BoE might be forced to temper its easing cycle. For now, the balance of risks seems to favour GBP resilience, especially against a structurally weaker dollar.

In Asia, the yen continues to be the weakest link among G10 currencies, at least for now. That’s not to say the fundamental case for yen strength has disappeared it hasn’t but rather that the market remains unconvinced. A mixture of global risk appetite, higher US yields, and the Nippon Steel US Steel deal (which may have triggered large-scale yen selling) weighed on JPY in May. Yet there’s a building case that BoJ policy may need to adjust again soon. With volatility in the long end of the JGB curve and banks trimming their super-long JGB holdings, the BoJ could pivot toward more dovish messaging, even if it avoids additional hikes. If risk sentiment fades and Treasury yields compress under softer US data, USD/JPY could finally roll over. For now, the pair remains a battleground between policy divergence and investor nerves.

The renminbi, meanwhile, continues to defy its fundamental at least partially. Despite weak domestic demand, a fragile housing market, and ongoing trade friction, the yuan has remained relatively stable against the dollar. This stability appears more about dollar weakness and PBoC management than inherent strength in China’s economy. May’s data was mixed: exports surprised to the upside, but much of that came from rerouting trade away from the US, which looks unsustainable given Trump’s focus on closing those loopholes. New US tech sanctions and student visa restrictions have further strained the bilateral relationship, making a breakthrough in tariff negotiations increasingly unlikely without a high-level intervention. Markets are watching for a Trump-Xi call, but until that materializes, expectations for any détente will remain low. The yuan looks vulnerable, and if export momentum fades in H2, downside pressure will return.

Turning to the commodity bloc, the Australian dollar continues to track global sentiment more than domestic fundamentals. A surprisingly strong April jobs report and sticky inflation weren’t enough to prevent the RBA from cutting rates again, and the tone from policymakers remains dovish. Still, with the US dollar on the back foot and China’s outlook stabilizing (even if only slightly), AUD/USD may have room to grind higher. That said, any renewed spike in trade tension or broader risk-off shift would likely hit AUD hard its path higher is far from guaranteed.

The kiwi dollar posted modest gains in May, benefiting from broad dollar weakness and a more balanced message from the RBNZ. Although the central bank cut rates again, it signalled the easing cycle might be nearing its end, depending on how the data evolves. With New Zealand’s GDP growth barely positive over the last two years, spare capacity remains ample. If global growth weakens further or China slows more decisively, NZD could underperform relative to AUD, especially with the RBA likely to pause before the RBNZ does.

Lastly, the Canadian dollar continues to be caught between two opposing forces: improving oil prices on one hand and proximity to the US economy on the other. Inflation picked up more than expected in April, partly due to retaliatory tariffs, but growth remains fragile and the BoC is expected to cut at least twice more this year. With Canada so tightly linked to US trade and financial conditions, any US downturn is bound to spill over. While the USD/CAD downtrend remains intact, the loonie may lag other G10 gainers in a broad dollar selloff scenario.

In sum, the FX market remains on edge, with trade policy once again acting as the principal driver of volatility. The disconnect between central bank signalling and fiscal policy realities especially in the US creates a narrative where dollar weakness may persist, but with intermittent corrections. For now, the bias remains to fade dollar rallies and continue favouring currencies with stronger fiscal backdrops, relatively independent central banks, and less exposure to geopolitical frictions. That list, increasingly, includes the euro and the pound and leaves the dollar on the defensive through the rest of the summer.

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