The US dollar has been buoyed by rising US 2-year yields and firm energy prices, with markets fully pricing one Fed rate hike by January 2027. At the pump, US average petrol prices are still above $5 per gallon. Inflation psychology has also firmed: the University of Michigan’s May survey put long-term inflation expectations at 3.9%, up from 3.5% in April, while its consumer sentiment gauge fell to a record low.
Positioning shows long USD exposure increased modestly over the past week, without appearing stretched, as attention turns to communication from new Fed Chair Kevin Warsh on the policy response to higher inflation risks, weaker consumer confidence and elevated US government debt. On geopolitics, Donald Trump said a largely negotiated Iran deal is in place, while Gulf states including the UAE, Saudi Arabia and Qatar are pushing for a diplomatic outcome and warning against escalation. The dollar’s momentum remains supported by yields and macro resilience, but a de-escalation could still trigger a sharp reversal.
Cautiously Bullish Dollar Strategy and Risk Management
We believe the immediate strategy is to maintain a cautiously bullish stance on the U.S. dollar, but with defined risk management. The persistent strength is driven by 2-year yields, which are reflecting sticky inflation data that recently showed the Consumer Price Index holding at 3.6% year-over-year. This environment supports trades that benefit from a strong dollar, like long positions in dollar index futures or call options on currency pairs like USD/JPY.
However, the primary risk is a sudden reversal on positive geopolitical news, specifically a finalized U.S.-Iran deal. To hedge this, we are looking at buying cheap, out-of-the-money put options on the dollar. These options offer a cost-effective way to protect against a sharp downward move should diplomacy succeed and the current risk premium vanish.
Energy and Derivatives as Geopolitical Hedges
The oil market provides another way to hedge this specific geopolitical risk, with Brent crude currently holding near $98 a barrel. We recall how the original 2015 nuclear deal led to a significant drop in oil prices, and we anticipate a similar, sharp reaction. Therefore, buying Brent or WTI put options for the coming months could be a valuable position that profits if tensions ease.
Given that markets are pricing a full rate hike by early next year, we also see opportunities in interest rate derivatives. Trading Fed Funds futures or options can capitalize on the market’s expectations for hawkish policy from the new Fed Chair. Weekly CFTC data shows speculative long dollar positions have grown for four consecutive weeks, suggesting the trade is becoming crowded and vulnerable to a quick unwind.
