When Rate Cut Hopes Fade: Dollar Surges While Markets Reassess 2026 Policy Path

The Dollar’s One-Month Peak Driven by Mixed Labor Data

The US dollar index climbed to its highest point in the past month on Friday, posting a 0.20% advance. Market participants credited the strength to a bifurcated employment report—December nonfarm payrolls rose by only 50,000 against expectations of 70,000, while simultaneously the unemployment rate dropped 0.1 percentage points to 4.4%, and average hourly earnings jumped 3.8% year-over-year, beating the 3.6% estimate. This contradictory signal—weaker job creation paired with lower unemployment and hotter wage growth—reinforced investor sentiment that the Federal Reserve will maintain a hawkish stance and delay interest rate reductions.

The employment disappointment appeared modest on the surface, yet the revision of November data to 56,000 from 64,000 told a deeper story about cooling labor dynamics. These readings, combined with remarks from Atlanta Fed President Raphael Bostic on Friday emphasizing persistent inflation despite labor market softening, solidified market expectations. The probability assigned to a 25 basis point rate cut at the January 27-28 FOMC meeting currently sits at just 5%—a sharp drop from earlier optimism.

Consumer sentiment data provided additional support for the dollar. The University of Michigan’s January index jumped 1.1 points to 54.0, surpassing the 53.5 forecast. Yet underlying inflation expectations remained sticky: one-year expectations held at 4.2% (above the anticipated 4.1%), while five-to-ten-year expectations rose to 3.4% from 3.2%, exceeding the 3.3% projection.

A court development added another layer of support. The Supreme Court postponed its ruling on the legality of Trump’s tariffs until next Wednesday, creating near-term uncertainty that favored safe-haven demand for the dollar. Should tariffs face legal challenges and be overturned, the resulting revenue loss could widen the US budget deficit—a scenario that might ultimately pressure the currency.

Housing Weakness Meets Service Sector Strength

October housing data revealed concerning trends. Residential construction fell sharply, with housing starts declining 4.6% month-over-month to 1.246 million—the lowest level in five and a half years and well below the 1.33 million forecast. Building permits slipped 0.2% to 1.412 million, suggesting future construction may also face headwinds, though the print still edged past expectations of 1.35 million.

These declines contrast with broader economic resilience. Service-sector activity, wages, and retail spending patterns suggested the economy retained underlying momentum despite housing’s pronounced drop.

Central Bank Divergence: Fed Easing Vs. Other Tighteners

Market pricing has evolved dramatically regarding 2026 policy trajectories. The Federal Reserve is now expected to cut rates by approximately 50 basis points over the course of 2026, a substantial reversal from earlier predictions. This dovish tilt stands in sharp contrast to anticipated moves by other central banks: the Bank of Japan is projected to raise rates by 25 basis points, while the European Central Bank is likely to hold rates steady.

Adding to downward pressure on the dollar, the Fed continues injecting liquidity into financial markets through $40 billion in Treasury bill purchases initiated in mid-December. Speculation regarding Trump’s potential dovish Fed Chair appointment—with Kevin Hassett mentioned by Bloomberg as a possibility—has also weighed on the greenback. The Trump administration plans to announce its Fed Chair selection in early 2026, introducing additional uncertainty into long-duration currency positioning.

Euro Holds Ground Despite Dollar Strength

EUR/USD experienced a 0.21% decline on Friday, sliding to a one-month low as dollar strength accelerated. However, the euro’s losses remained contained, supported by better-than-anticipated Eurozone economic data.

November Eurozone retail sales rose 0.2% month-over-month, exceeding the 0.1% estimate and with October’s figure revised upward to 0.3% from flat. German industrial production for November climbed 0.8%, defying expectations for a 0.7% contraction. ECB Governing Council member Dimitar Radev stated that prevailing interest rates remain appropriate given current data and inflation dynamics. Market pricing reflects only a 1% probability of a 25 basis point ECB rate hike at the February 5 policy meeting, suggesting European monetary policy is unlikely to shift materially in the near term.

Yen Tumbles to One-Year Low as USD/JPY Climbs

The USD/JPY pair advanced 0.66% on Friday, with the yen dropping to its lowest level against the dollar in one year. Bloomberg reporting indicated the Bank of Japan is likely to keep rates on hold at its upcoming meeting despite raising its domestic economic growth forecast. Markets currently assign zero probability to a rate hike at the January 23 BOJ meeting.

Japanese economic data showed mixed signals. The November leading composite index hit a 1.5-year peak at 110.5, matching expectations. Household spending surged 2.9% year-over-year in November, marking the largest increase in six months and far exceeding the expected 1% decline. Yet geopolitical headwinds—rising China-Japan tensions including new Chinese export controls on defense-related items, alongside reports that PM Takaichi may dissolve the lower house—pressured the yen. Japan’s government also plans to boost defense spending to a record 122.3 trillion yen ($780 billion) in the next fiscal year, raising fiscal concerns.

Precious Metals Rally on Stimulus and Geopolitical Unease

February COMEX gold surged $40.20 (+0.90%) on Friday, while March COMEX silver jumped $4.197 (+5.59%). The advance followed Trump’s directive for Fannie Mae and Freddie Mac to purchase $200 billion in mortgage bonds—a quantitative easing-style action aimed at stimulating housing demand and lowering borrowing costs. This stimulus-oriented move boosted safe-haven appeal for precious metals.

Ongoing geopolitical tensions—encompassing US tariff uncertainty, conflicts in Ukraine and the Middle East, and instability in Venezuela—continued to support metals demand. Forward-looking expectations of Fed accommodation in 2026, coupled with expanded financial system liquidity, further underpinned gold and silver prices.

However, the dollar’s rally to a four-week peak created headwinds for metals. Concerns about commodity index rebalancing posed a meaningful risk, with Citigroup estimates suggesting up to $6.8 billion could exit gold futures and a similar magnitude from silver positions due to index reweighting. Additionally, the S&P 500 hitting fresh record highs on Friday reduced safe-haven flows into precious metals.

Central bank accumulation remained a bright spot. China’s central bank increased gold reserves by 30,000 ounces in December, extending a fourteen-month buying streak. Global central banks collectively purchased 220 metric tons of gold in Q3, representing a 28% surge from the prior quarter. Gold exchange-traded fund holdings reached a 3.25-year peak, while silver ETF holdings climbed to a 3.5-year high in late December, signaling robust investor appetite for bullion exposure.