Dollar Gets Stronger on Tariffs Stories and Expected Hawkish Fed

The U.S. Dollar Index (DXY) rose by 0.45% to 107.92 points this week, while the EUR/USD declined by 0.60% to 1.04290. The Dollar strengthened amid a "tariffs roller coaster" sparked by U.S. President Donald Trump. On Sunday, Trump threatened Colombia with a trade war after its government refused to accept deported citizens from the United States. Colombia swiftly capitulated, agreeing to receive deportees within hours of Trump's warning.

This heightened volatility on Monday, with EUR/USD initially dropping by 0.36% to 1.04560 at the opening, then rebounding by 0.76% to 1.05330 before closing neutrally at 1.04900. While the immediate tariff-related drama seemed to have settled, Trump reignited concerns by announcing new tariffs on foreign pharmaceuticals, semiconductors, and metals. The news pushed EUR/USD down by 0.60% to 1.04200.

Despite the tariff threats, U.S. 10-year Treasury yields held steady at 4.55%, suggesting investors are either awaiting concrete actions from Trump or anticipating the Federal Reserve's reaction to these developments.

Both scenarios are plausible. Trump is highly attuned to market responses, and if his actions negatively impact the stock market in the long term, he is likely to backtrack. A significant rise in tariffs could trigger a chain reaction, including higher borrowing costs and declining equity markets, which runs counter to Trump’s agenda of economic expansion and market growth. His strategy seems more focused on short-term victories rather than prolonged trade wars.

However, Trump's brinkmanship carries risks. Missteps could lead to unintended trade tensions, though investors currently see no immediate threats. The EUR/USD is expected to resume its upward trajectory towards 1.09500–1.10500 following a potential correction. Support is seen around 1.03500–1.03700 as the lowest level in the near term.

The Federal Reserve is set to meet on Wednesday and is expected to leave interest rates unchanged. However, Chair Jerome Powell’s press conference may feature hawkish remarks, which could provide short-term support for the Dollar. Even so, significant Dollar gains seem unlikely, as Trump could openly criticise the Fed to counteract any strength in the currency.

The European Central Bank (ECB) will hold its policy meeting on Thursday, and U.S. Q4 2024 GDP estimates, along with the December PCE Index, are also due this week. These events will likely be viewed through the lens of the evolving dynamics between Trump and Powell.

Investor sentiment remains cautious. The WisdomTree Bloomberg US Dollar Bullish Fund (USDU) reported net inflows of $2.76 million, indicating that large investors may be positioning for a Dollar rally during the EUR/USD correction before closing their bets on Dollar strength.