Morgan Stanley: The dollar may remain weak in the near term; turn bullish on DXY near EUR/USD 1.1350

Why does near-term dollar weakness not mean a reversal of the medium-term outlook?

The report says declines in energy prices and equities have amplified dollar volatility; if energy prices continue to fall and weigh on US yields, DXY still has room to decline in the short term. Position rotation could also amplify this bout of volatility.
But Morgan Stanley believes economic data still supports risk appetite and that the Carry Regime in its dollar framework may continue: investors favor selectively holding high-yielding risk currencies and funding in euros or yen, rather than extrapolating near-term dollar weakness directly into a medium-term trend.

Morgan Stanley compared the impact of changes in energy prices during 2026 on central-bank pricing: pricing for the European Central Bank and Bank of England was more affected by energy than pricing for the Federal Reserve. Therefore, if energy prices continue to fall, US interest rates may decline less than their European counterparts, with the interest-rate differential instead supporting DXY.
The French-German 10-year government bond yield spread remains about 100 basis points wider than in May. The bank believes wider sovereign spreads will weigh on European growth and inflation; together with uncertainty surrounding the change in European Central Bank leadership, there is still room for markets to lower their expectations for European interest rates.
Markets are currently pricing in only about 30 basis points of Federal Reserve rate hikes through March 2027, or fewer than two hikes for the year. Morgan Stanley believes that if the Fed raises rates in December as expected, and the US core inflation it forecasts rebounds in the first quarter of 2027 due to seasonal factors, markets may revise up the interest-rate path for 2027.

With the French election approaching, Morgan Stanley expects investors to be more cautious about eurozone risks and believes the euro may become a preferred funding currency until the French election is settled by mid-2027. The bank judges that the risk premium in the euro’s relative interest-rate differential against the dollar still has room to decline.
The pound faces a different constraint: the UK economic surprise index is at its 93th historical percentile, markets have priced in nearly three additional rate hikes, and long positions in the pound against the euro are near record highs. Morgan Stanley is therefore not bullish on sterling holding above 1.35 against the dollar.

Near-term position squeezes may continue, and technical indicators for DXY and EUR/USD are not yet in clearly overbought or oversold territory. Morgan Stanley therefore has not recommended chasing the dollar higher immediately, instead waiting for exchange rates to offer a better entry point.
If EUR/USD rebounds to 1.1350–1.14, the bank plans to increase its short euro position and turn bullish on DXY; its model indicates that, with the combined effects of repricing in central-bank rate expectations and European political risks, the fair value of EUR/USD is below 1.10 and could even approach 1.05.

If the dollar weakens while risk appetite remains strong, the bank still favors funding long positions in risk currencies with euros and yen; its historical analysis shows that this type of strategy has still delivered positive average returns during dollar bear markets. Thus, being long DXY does not mean abandoning all risk-currency positions.
Energy prices are an important countervailing variable: the bank views the Swedish krona as a clear beneficiary of falling energy prices, while the Norwegian krone is more sensitive to energy prices. Morgan Stanley retains a long NOK/SEK position to hedge against an oil-price rebound; short EUR/CHF is used to hedge against increased volatility in European sovereign spreads.