Morgan Stanley warns dollar rally may be bull trap amid growth risks

Summary:

• Dollar rises ~2% since Iran conflict began
• Gains driven by safe-haven demand, energy dynamics
• Morgan Stanley warns rally may be a bull trap
• Markets seen underpricing growth-negative impact
• Fed expected to cut rates twice this year
• ECB may hike to counter energy-driven inflation
• Narrowing rate differentials seen as USD headwind
• Dollar downside risk if growth slows

Morgan Stanley has cautioned that the US dollar’s recent rally may prove short-lived, warning that current strength could represent a “bull trap” as underlying macro dynamics shift against the currency.

The dollar has appreciated by around 2% since the outbreak of the Iran conflict, supported by a combination of safe-haven demand and higher energy prices. This move has coincided with weakness in major counterparts such as the euro and yen, as markets sought liquidity and relative stability amid rising geopolitical risk.

However, Morgan Stanley strategists argue that the rally may not be sustainable. They suggest markets are underestimating the negative impact of the conflict on global growth, which could ultimately weigh more heavily on the US economy than currently priced.

A key factor behind the bank’s view is the expected shift in monetary policy divergence. Morgan Stanley anticipates that the Federal Reserve will deliver two rate cuts this year as growth slows, contrasting with expectations for the European Central Bank to move in the opposite direction by tightening policy to counter inflation pressures driven by higher energy costs.

This narrowing of interest-rate differentials, historically a key driver of currency trends, is seen as a potential headwind for the dollar. As yield advantages erode, the relative appeal of holding US assets may diminish, particularly if growth concerns begin to dominate market sentiment.

The bank characterises the recent price action as a classic “bull trap,” where initial gains draw in investors before reversing as the underlying fundamentals reassert themselves.

Markets will be watching closely for confirmation of this view through incoming economic data and central bank signalling. If growth risks materialise and policy expectations shift accordingly, the dollar could face renewed downside pressure despite ongoing geopolitical uncertainty.