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Investing.com-- The U.S. dollar is losing steam as the Federal Reserve prepares to resume rate cuts, but Capital Economics says the greenback’s outlook remains steadier than many expect.
"We no longer expect much of a rebound in the U.S. dollar this year as the FOMC is about to resume rate cuts," Capital Economics said in a Tuesday note just a day ahead of the Fed rate decision. "But given the extent of Fed easing already discounted, our base case remains that the dollar will stabilise from here rather than fall much further."
Recent declines in U.S. interest rate expectations and softer employment data have pressured the dollar.
Money markets are now pricing in about 150 basis points of Fed cuts over the next year, up from 100 basis points in July. Capital Economics, however, believes the drop in growth and rate expectations may be overdone, noting the economy still looks solid despite a slowdown partly driven by immigration policy changes.
The ongoing surge in AI investment poses upside risks to economic growth and, by extension, the dollar. Inflation staying above target also suggests the Fed will avoid rapid easing.
Capital Economics contrasts this with subdued growth in Europe and much of Asia, expecting other major central banks to maintain dovish but less aggressive policies than the Fed. The resulting interest rate differentials should support the dollar over the next year or so.
But his call of dollar recovery over the next year comes with caveats. Downside risks include a more serious U.S. slowdown or recession triggering looser Fed policy than currently priced, which could weaken the dollar especially against currencies like the euro and yen. Political risks from attempts to influence Fed policy also pose challenges.
The U.S.-centric AI boom, meanwhile, continues to prop up equity markets and capital inflows, potentially fueling a dollar rebound if productivity and growth expectations rise.
Despite roughly a 10% dollar drop this year, Capital Economics says the greenback remains above its long-term average on a real trade-weighted basis, leaving some room for depreciation, particularly against Asian currencies, where much of the overvaluation lies.
Overall, the firm has trimmed its dollar rebound expectations this year but remains more optimistic on the dollar’s long-term prospects than most analysts.