'We were wrong.' Why Morgan Stanley changed its tune on the U.S. dollar - and what it expects now.

By Jamie Chisholm

Rising bond yields and expected Fed rate hikes have wrecked the bank's forecast for the buck

Morgan Stanley expects more bang for the buck.

Surging Treasury yields have not only been in sharp focus for equity investors of late; they've also made their impact on the foreign exchange market, helping push up the U.S. dollar.

The dollar index DXY, which measures the greenback against a basket of currencies, hit an eight-week high around 101.40 this week.

The stronger buck may be good news for Americans looking to travel abroad, but it can be a drag on U.S. companies whose products become more expensive for foreign buyers. Indeed, just this week President Donald Trump raised the issue of the yen's weakness against the dollar with Japanese Prime Minister Sanae Takaichi.

The dollar's rally has also caught many on Wall Street off-guard. "We were wrong," said a team of Morgan Stanley currency strategists led by David S. Adams.

In a note published Friday, they admitted their rationale for forecasting a weaker dollar has come unstuck. They expected the dollar's descent to continue into the second half of the year before bottoming near the end of the year, then turning higher in 2027.

"This was premised on a convergence in U.S. rates with those abroad as the Fed remained on hold and other central banks caught up," said the Morgan Stanley team.

This dollar weakness would also cheapen foreign-exchange hedging costs, they believed, allowing foreign investors concerned about the U.S. dollar's long-run status to bolster their foreign-exchange hedges, which in turn would amplify the buck's weakness.

Under this scenario, Morgan Stanley predicted that the dollar index would end this year at 96. The dollar would weaken to 1.20 per euro (EURUSD), slip to 1.38 per British pound (GBPUSD), and the Japanese yen would be 157 per buck (USDJPY).

They've now had to shift those targets to reflect dollar strength, to DXY 102, EUR 1.12, GBP 1.30, and JPY 159. And the reason the U.S. currency has been rallying should be clear to most market watchers - an unexpected jump in the chances of higher interest rates in the U.S., which can make the dollar more attractive.

"Elevated energy prices, robust U.S. [economic] data, and a hawkish Federal Open Market Committee reaction function has generated not just a rate hike but likely further hikes to come," said Morgan Stanley.

Currently, interest-rate-futures traders are pricing in a 68.6% chance the Fed will raise borrowing costs by 25 basis points, to a range of 4.00% to 4.25%, at its October meeting, according to CME FedWatch. Another such hike in December is priced at 54.8%.

"The market has ample capacity to price hikes well beyond what economic fundamentals would justify for a modal expectation, which only further bolsters the greenback," said Morgan Stanley.

Looking into mid 2027, they see the DXY at 104 as the EUR drops to 1.10 amid revived fiscal and political concerns in Europe. The bank suggested maintaining a long position on the USD/JPY at 158, a bet on dollar strength versus the yen, with a target of 163 and a stop at 150.

However, Morgan Stanley had some caveats for its dollar-strength call.

The buck's gains will mostly come from lower-yielding currencies that will continue to be used to fund carry trades - the strategy by which investors borrow in those currencies to seek higher returns elsewhere - such as the yen, euro and Swiss franc. They also think the pound will be weak, but so-called commodity currencies, like the Australian dollar (AUDUSD) and Norwegian krone (USDNOK), will be strong.

Morgan Stanley also accepted that the moves they are outlining are not particularly large. "Take our forecast of EUR/USD to 1.10 in mid-2027, for example. At the time of writing, the market-implied probability of EUR/USD reaching 1.10 by mid-2027 is about 35%, suggesting it's a pretty foreseeable event for investors," they say.

Finally, Morgan Stanley recognized the dollar can be hit badly by shocks such as Trump's "liberation day" tariff announcement and yen intervention.

"We're worried that [U.S. dollar] longs may be 'stopped out' [forced to close a position] by an unexpected shock down the line, even if the fundamental case for USD strength is greater and the most likely outcome is a stronger USD over time," they said.

The markets

U.S. stock-indices SPX DJIA COMP are higher at the opening bell on Wall Street as Treasury yields BX:TMUBMUSD10Y dip. The dollar index DXY is lower, as oil futures (CL.1) slip and gold futures (GC00) trade around $4,329 an ounce.

 
Key asset performance                                                Last       5d      1m      YTD     1y 
S&P 500                                                              7704.13    0.87%   -0.35%  12.54%  16.65% 
Nasdaq Composite                                                     26,939.37  1.97%   1.50%   15.91%  20.35% 
10-year Treasury                                                     5.171      17.40   45.40   99.90   99.50 
Gold                                                                 4328.9     -1.97%  -3.89%  -0.08%  14.23% 
Oil                                                                  92.68      -2.92%  11.07%  61.44%  42.17% 
Data: MarketWatch. Treasury yields change expressed in basis points 

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The buzz

Iran has offered the U.S. a new "7-day" proposal to reopen the Strait of Hormuz and to restart broader talks towards a final resolution to the war, according to the Financial Times.

Akamai Technology shares (AKAM) are surging after the cybersecurity and cloud company agreed a $12 billion deal for computing infrastructure with AI lab Anthropic.

U.S. durable-goods orders for August were flat month-on-month, but better than economists' forecasts of a 0.3% contraction. The University of Michigan final consumer survey for September is published at 10 a.m.

Cleveland Fed President Beth Hammack speaks at 2 p.m.

The robust U.S. economy powers through rate hikes and rising bond yields.

The chart

Source: DataTrek Research

A chart of 2-year Treasury yields BX:TMUBMUSD02Y from 2022 to the present "shows why 5% for this maturity is very likely the equity market's proverbial 'line in the sand,'" according to Nicholas Colas, co-founder of DataTrek Research. If the 2-year yield breaches that level, equities will discount incremental recession risk since this scenario suggests that Fed policy rates will be higher than at any point in recent memory, according to Colas. Investors may remember that the dot-com bubble started to burst in the first half of 2000 when the Fed took rates to new cycle highs. "This started the process of compressing equity valuations, and the same is certainly possible now," Colas added.

Top tickers

Here were the most active stock-market tickers on MarketWatch as of 6 a.m. Eastern.

 
Ticker  Security name 
NVDA    Nvidia 
GME     GameStop 
TSLA    Tesla 
MU      Micron Technology 
AMD     Advanced Micro Devices 
AMZN    Amazon.com 
SPCX    SpaceX 
META    Meta Platforms 
AAPL    Apple 
INTC    Intel 

Nana the seal swims 200km back to island after missing humans.

-Jamie Chisholm

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09-25-26 0930ET

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