Morgan Stanley is completely overhauling its previous judgment on the dollar. The bank's FX strategy team has just raised its year-end dollar index target from 96 to 102, and made clear that its earlier logic for a weaker dollar has now failed. The dollar index briefly climbed to around 101.40 this week, hitting roughly an eight-week high.

Previously, Morgan Stanley expected the dollar to keep weakening through the second half of this year, bottom out near year-end, and then recover in 2027. That view rested on the premise that U.S. rates and those of other major economies would gradually converge, meaning the Federal Reserve would stay on hold while other central banks kept tightening. The actual rate path has diverged from that assumption.

Morgan Stanley pointed out that with energy prices staying elevated, U.S. economic data remaining strong, and the Fed's policy response clearly more hawkish, the market has shifted from expecting the Fed to stand pat to pricing in further hikes.

Rate differentials once again become the most direct support for the dollar

Interest rate futures currently show the Fed is expected to raise rates by another 25 basis points in October, with roughly a 68.6% probability of lifting the federal funds target range to 4.00%-4.25%. The market is also pricing in about a 54.8% probability of another 25 basis point hike in December. Higher U.S. rates directly lift the yields on dollar assets. For global investors, when returns on dollar deposits, Treasuries and other dollar-denominated fixed income assets rise, the opportunity cost of holding dollars falls, and the FX market naturally reallocates capital.

Morgan Stanley had previously expected EUR/USD to rise to 1.20 and GBP/USD to rise to 1.38 by year-end, but has now adjusted those targets to 1.12 and 1.30 respectively. Its USD/JPY target was revised from 157 to 159, reflecting the bank's reassessment of overall dollar strength. The bank further expects the dollar index could rise to 104 by mid-2027, with EUR/USD falling to 1.10. The strategy team also recommends maintaining a long USD/JPY bias, with a reference entry level around 158, a target of 163, and a stop-loss at 150.

This dollar rally looks more like a rate repricing

A rising dollar is usually simply attributed to safe-haven inflows, but the core of Morgan Stanley's latest adjustment is not risk sentiment — it is rate expectations. The renewed upward shift in the U.S. terminal rate has interrupted the trade logic that had bet on narrowing U.S.-Europe rate differentials. The bank believes dollar strength is most easily expressed against low-yielding currencies. The yen, euro and Swiss franc remain common global funding currencies for carry trades, as investors can borrow these currencies cheaply and then allocate to higher-yielding dollar assets, so when rate differentials widen, the dollar more easily attracts sustained buying.

Morgan Stanley also believes this logic does not affect all currencies equally. Commodity currencies such as the Australian dollar and Norwegian krone may prove more resilient due to their own economic and commodity price factors, with the dollar's advantage mainly concentrated among low-yielding funding currencies.

The dollar index is now not far from the bank's year-end target of 102, so further upside depends more on whether the market continues to raise the number of expected rate hikes. If expectations for October and December hikes strengthen further, short-end yields such as two-year Treasuries may continue to rise, and the dollar's rate advantage will expand accordingly.

Morgan Stanley also warned that dollar bulls could still be hit by sudden events. The bank believes that even if medium-term fundamentals are more supportive of a stronger dollar, unexpected policy changes or events such as yen intervention could force crowded long positions to unwind quickly in the short term.