Barclays: Dollar rally is a "bitter victory," easing geopolitical tensions will trigger pullback

Barclays Bank believes that for bulls, the recent strength of the US dollar seems like a feast, but it is only a “bitter victory.”

According to market reports, on March 24, the Barclays research team stated that the energy price shocks triggered by the escalation of Middle East tensions have certainly boosted the dollar. However, the dollar’s continued lag relative to interest rate differentials indicates that approximately 5% of “dollar risk premium” has become deeply ingrained and difficult to dissipate.

Once the Middle East situation stabilizes in the coming months and energy prices fall back, the dollar will face unavoidable short-term weakness and corrections.

Dollar Strength, But Not Enough

The Barclays report pointed out that after the outbreak of conflict in Iran and the Middle East, the dollar demonstrated its traditional advantages—energy independence, technological leadership, and economic resilience.

Data shows that for every 10% increase in oil prices, the dollar tends to appreciate about 0.5% to 1% against major currencies like the euro and the pound.

(When oil prices rise by 10%, the USD exchange rate increases by 0.5% to 1%)

However, the dollar’s performance still significantly lags behind traditional benchmarks such as interest rate differentials. For example, the fair value of EUR/USD based on the 10-year real interest rate differential is about 1.10, but the actual exchange rate trades around 1.15.

(Lagging behind the trend of interest rate differentials)

The core reason for this divergence is a persistent and high “dollar premium” of about 5%. This premium has hovered near the critical threshold of 1 standard deviation (1-sigma) for over a year, far exceeding historical norms.

(Dollar premium situation)

The report defines the “dollar premium” as: The difference between the actual level of the EUR/USD exchange rate and its “fair value” calculated based on the 10-year real interest rate differential, relative stock performance (MSCI US/Europe ratio), and other factors.

Specifically, the report uses a regression model to quantify this premium. The model regresses EUR/USD against multiple variables, and the “dollar premium” is the residual of this regression model.

What sustains this premium? Barclays believes it is increasingly highly correlated with US-specific risk factors, namely, domestic economic policy uncertainty and valuation fluctuations in the US tech sector.

This premium did not dissipate during the escalation of Iran tensions, implying that current long-dollar investors are actually bearing very high and unpredictable policy communication risks.

Structural Factors Reshaping Dollar Logic

In the past, when global risk increased, the dollar benefited from its safe-haven status, and the premium was often negative, meaning the dollar was more expensive.

But since 2025, the situation has reversed. US domestic economic policy uncertainty has soared, and this correlates positively with the dollar premium. Markets are now demanding compensation for the “US domestic policy risk” associated with holding dollars.

(The premium level reflects US-specific policy risks)

Another driving factor is the tech sector. Previously, the rise of US tech stocks symbolized “American exceptionalism,” which was favorable for the dollar. But now, concerns over AI disruptions may cause tech stock gains to be negatively correlated with the dollar premium, weakening the dollar’s appeal.

(Impact of the tech sector)

Recent Outlook for the Dollar: Soft Landing, No Rapid Drop

Based on this, Barclays offers a balanced outlook for the dollar. Currently, the dollar is supported by high oil prices and geopolitical risks. But if the dollar premium persists during favorable conditions, it is likely to continue after tensions ease.

Therefore, if conflicts ease in some form within the next quarter and oil prices decline, the dollar will face downward pressure. Meanwhile, domestic US agendas, such as midterm elections and the new Federal Reserve chair, may sustain the premium.

However, thanks to AI-related capital expenditures and fiscal tailwinds, the resilience of the US economy will prevent a collapse-driven decline of the dollar.

By early next year, markets may start to focus on potential fiscal deadlocks following the midterm elections. If new fiscal stimulus legislation fails to pass, market expectations for growth in the last two years of the Trump administration could cool.

Overall, Barclays analysts expect the EUR/USD to remain within the range it has traded since April last year for a long period.

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