Surging oil prices from the Gulf war stoked inflation and killed rate-cut hopes, while a hawkish Warsh Fed and central bank divergence now underpin the dollar's sharpest recovery in years.
The U.S. Dollar Index (DXY) continued to grind higher in Thursday's session despite two seemingly opposing forces acting on the greenback: a hawkish Federal Reserve under its new chair, Kevin Warsh, which reinforced expectations of tighter monetary policy at its June meeting, and easing geopolitical tensions following the U.S.-Iran peace agreement electronically signed on Wednesday.
Caught between these competing catalysts, where is the greenback headed in the near term? Before exploring the dollar's outlook, it's worth examining how the U.S. currency has traded so far this year amid a rapidly evolving macroeconomic and geopolitical landscape.
How the Gulf War Gave the Battered Dollar Its Bite Back
The dollar entered 2026 nursing a significant hangover. The DXY closed 2025 at 98.28, a nearly 10% drop for the year, its worst annual performance since 2017. Notwithstanding the dollar’s dismal performance, the currency still remained overvalued relative to major peers, according to RBC Capital Markets.
Currency Purchasing Power Parity Valuation
Source: RBC Capital Markets
Fast forward to June 2026, and the picture has reversed sharply. The Iran energy shock revived inflation fears, killed the rate-cut narrative, and a hawkish Warsh Fed has now pushed DXY back above 100 to a one-year high, erasing part of 2025's losses in a matter of months.
DXY Weekly: From 109 to 96 and Back Above 100
Source: TradingView
The dollar strength defied the predictions of most strategists at the start of the year, as the U.S.-Iran war threw a curve ball into their pessimistic outlook.
What Powered This Year’s Dollar Rally
The upward thrust for the dollar came primarily from the Gulf war that sent oil prices soaring as high as $120 a barrel. The oil shock fed directly into inflation in the U.S. and elsewhere. Specifically in the U.S., theMay headline inflation printed at 4.2%, marking a three-year high, with the core reading also running hot at 2.9%.
Source: TradingView
The annual rate of the core Price Consumption Expenditure Index, often referred to as the Fed’s preferred inflation gauge, also runs well above the 2% central bank target.
Source: TradingView
An inflationary environment diffused all rate-cut hopes the market began pricing in, and was the fundamental driver of the dollar in 2026.
Morgan Stanley, for one, predicted in November last that the dollar depreciation will deepen in the first half of 2026 followed by a recovery and an end to the bear market in the second half of the year.
Specifically, the firm called for the DXY to drop to 94 in the second quarter of 2026, which would have marked the lowest since 2021. Here we are, with a dollar that has defied the dire prediction and moved in the opposite direction.
Morgan Stanley has since updated its prediction for the dollar, pushing out its pessimistic forecast to the second half. In a mid-year update to its 2026 outlook published in mid-May, the firm said it expects the dollar to remain weak, relative to its peers in the H2’26. The premise for the anticipated weakness is the expectation: core inflation moderates, probability of rate hikes moderates and global risk appetite strengthens.
Meanwhile, Goldman Sachs had predicted a shallow descent for the dollar in a report released in January. “The sturdy global growth and more balanced returns that we expect should weigh on the Dollar given its usually negative correlation with risk sentiment,” the firm said.
Will the dollar put forecasters on the wrong side of the trade and build on its strength, six months out from now?
3 Factors Crucial for Dollar’s Trajectory
Iran Peace Deal: Will It Hold — and How Fast Does the Oil Bull Trade Unwind?
This is the most direct threat to the dollar bull case as it shakes the very foundation on which the dollar rally seen now has been built. Following Sunday’s announcement regarding the signing of a peace deal, the West Texas Intermediate (WTI) crude contract has shed more than 12%. With Pakistan Prime Minister Shehbaz Sharif confirming that the “Islamic Memorandum of Understanding” has been signed between the U.S. and Iran, oil has extended its slide on Thursday.
https://x.com/CMShehbaz/status/2067403784419254306
MarketFramework data shows,futures traders are bullish on the CL contract despite the recent pullback in prices, and it was among the most actively traded contracts on the platform.
The International Energy Agency (IEA) said in its June forecast a supply glut in 2027. The agency estimates supplies to surge by 8 million barrels per day (mb/d) next year to 110 mb/d while oil demand is projected to rise by a modest 2 mb/d to 105.3 mb/d. If that supply glut materialises, energy-driven inflation, the very force that killed the rate-cut narrative and powered the dollar's 2026 recovery, begins to unwind.
That said, analysts and experts fear that it would take months for normalcy to resume in Hormuz strait. According to trade data firm Kpler, shipping through Hormuz could rise to 50% of prewar levels within a month if the Iran deal is implemented without any major hiccups, CNBC reported.
Against the backdrop, the possible scenarios are:
- A slow drip lower in crude keeps inflation sticky and the dollar supported.
- A sharp collapse in oil prices removes the Fed's hawkish cover almost overnight.
The peace deal is signed, but the Strait still needs demining, ships need to flow freely, and damaged energy infrastructure needs rebuilding. Until the process accelerates, the dollar will retain its inflation-driven support.
Fed Rate Expectations
Wednesday’s Federal Open Market Committee (FOMC) statement, the updated inflation forecasts and the dot-plot chart, along with Warsh’s press briefing has pushed up the odds of rate hikes through this year. More importantly, Warsh refrained from giving his projections that go into the dot-plot. Any shift in inflation and growth data points will alter the future Fed policy trajectory and in turn impact the dollar.
The futures market has begun pricing in 32.1% odds of a rate hike as soon as late July, with the hike probability rising to 67% in September, 75.8% in October and 85% in December. Rate cuts are priced out for this year. The bond market reaction confirmed market’s rate hike expectations. The 2-year Treasury note yield, which is closely aligned to short-term interest rates, spiked to 4.20% following the rate decision, the highest since early 2025.
For now, the rate hike runway gives the dollar its clearest fundamental support in 18 months, But with hike expectations this aggressively priced, the dollar is only one disappointing inflation print away from a sharp reversal.
Central Bank Divergence
The dollar's performance depends not only on the Fed but also on what other major central banks do. If the U.S. economy remains more resilient than those in Europe, Japan, or other developed markets, and if their central banks remain more dovish, the dollar could continue to outperform.
DXY Bulls Take Control
The DXY has staged a decisive breakout above the upper boundary of the ascending channel it has been trading within since mid-May, a technically significant development that points to accelerating bullish momentum. The simple moving average (SMA) ribbon reinforces the constructive outlook, with shorter-term averages — the 20-day at 99.59 and 50-day at 99.53 — sequentially stacked above the longer-term 100-day and 200-day SMAs at 98.77 and 98.70 respectively, a classic bullish alignment.
Channel Breakout Signals Bullish Momentum as RSI Approaches Overbought Territory
Source: TradingView
The 14-day relative strength index (RSI) has climbed to 67.53, closing in on the overbought threshold of 70. This is a sign that momentum is running hot and traders should watch for a potential consolidation before the next leg higher. On the downside, the immediate support is now the 99.59 level, the former resistance zone that, having been convincingly breached, should ideally flip to support on any pullback. A deeper retracement could test the confluence of the 100-day and 200-day SMAs clustered around 98.70–98.77.
Traders looking to initiate a long position would be better served waiting for a pullback toward the 99.59 level, the former resistance zone that should ideally flip to support, rather than chasing the breakout at current levels. The upside targets are around the 100.6, which happens to. be the 52-week high, followed by the 101 psychological barrier.