Foreign Exchange Commentary

Navigating Currency Markets in 2026–2027

The Future Path of U.S. Monetary Policy

As of late 2025, U.S. monetary policy sits at a delicate crossroad. The Federal Reserve (Fed) has slowed the pace of quantitative tightening after an extended tightening cycle that began in 2022, which successfully pulled headline inflation down from double-digit highs. Core inflation, however, remains stubbornly above the Fed's 2% target, and the labor market has firmly shown signs of cooling. Jobless claims, which have been averaging around 230,000 this year are showing that labor-intensive sectors such as construction and manufacturing are seeing and lower hiring rates and younger people are finding it harder to find jobs postgrad.

Looking ahead, the Fed’s path in 2026 and 2027 will be shaped by two interconnected forces: domestic political pressure and the balance between inflation and employment stability. Federal Reserve Chairman Jay Powell's term is set to expire in May 2026, and markets widely expect President Trump to nominate a successor who is viewed as more sympathetic to the administration's growth agenda. This transition raises concerns that the Fed's full independence could be compromised, with appointments to the Board of Governors increasingly tilted toward figures loyal to the current administration. FX observers should expect a more politicized monetary stance, where rate cuts or pauses may come sooner than inflation dynamics justify, particularly if growth slows ahead of the 2026 mid-term elections.

As we move into the new year, considerations will probably lead to a more accommodative stance, risking renewed inflationary pressure in 2027. By that point, traders must be prepared for a less predictable policy environment, where the Fed's credibility in anchoring inflation expectations could be called into question.

The Tariff Shock and Its Economic Implications

The Trump administration's sweeping tariff package—particularly on Chinese goods, select European imports, and Mexican manufacturing components—is currently recalibrating supply chains: though it is currently under the threat of repeal from the courts, which could induce further volatility to markets. However, the current phased implementation means much of the economic drag will be felt in 2026 and subsequent years, coinciding with political uncertainty at the Federal Reserve.

Tariffs will add to import costs: forcing businesses to either absorb higher input costs or pass them on to consumers. Second, while tariffs are intended to boost U.S. manufacturing, the country faces a chronic shortage of skilled industrial labor and higher production costs relative to competitors in emerging economies. The U.S. dollar, as the world's reserve currency, has provided the U.S with the ability of running persistent current account and budget deficits, but this same dynamic raises the cost of ramping up domestic production quickly. U.S. firms will remain at a cost disadvantage and it is unlikely they will be able to ramp up manufacturing capacity in the short term due to structural issues, which include a lack of a skilled manufacturing workforce, the long time lag required to build manufacturing facilities, and the fact that much of the specialized technology require to scale manufacturing is currently concentrated in Asia and Europe. Therefore, reshoring efforts are more likely to be inflationary than growth positive. At least in the short term.

The net result is likely to be stagflationary pressure, meaning higher consumer prices with limited capacity gains. Investors should not expect a rapid revival of U.S. industrial competitiveness but rather an adjustment period with protracted real GDP growth.

Exchange Rate Impacts of Uncertainty

Donald Trump's return to the White House in January 2025 triggered higher volatility in global currency markets. Investors quickly reassessed U.S. policy trajectories, factoring in the aggressive use of tariffs, protectionist trade policies, and looser fiscal discipline. Heading into inauguration day, the U.S. dollar strengthened on expectations of higher inflation and interest rates, but this rally was short lived as investors recalibrated their exposure to the U.S.

In 2025 the euro currency has rallied nearly 15% against the U.S dollar going from ~1.0250 at the beginning of January to 1.1780 at the time of writing. While some of the factors for this rally include productive growth in the euro-zone, dovish U.S. monetary policy and a recalibration of risk premiums for U.S assets are factors traders must remain wary of: Europe's structural fragilities - particularly regarding energy, fiscal fragmentation defense, and more expensive barriers to reach U.S consumer. Contrary to the recent past, the euro currency has been rallying while interest rate differentials favor the U.S dollar.

The British pound-sterling has also rallied. Primarily driven by U.S dollar weakness, the effects of tariffs and domestic concerns regarding sluggish growth combined with high fiscal deficits and inflation should be a drag for sterling in 2026.

Though the Canadian dollar caught a year-end bid, it underperformed for the large part of the year, reflecting both tariff risks on auto exports and softer commodity prices for oil in addition to a muted year of GDP growth. Meanwhile, the Mexican peso has been one of the most sensitive currencies, with tariff headlines generating sharp intraday moves daily. Despite Mexico's disciplined central bank policy, uncertainty over access to the U.S. market has kept investors cautious.

While nearly all G-10 currencies outperformed the U.S. dollar this year, the Japanese yen remains weak as the nation battles sticky core inflation and a new government with looser fiscal discipline. The Bank of Japan, which recently raised its benchmark interest rate to 0.75%, the highest level in 30 years has seen record spikes in its borrowing costs with Japanese government bond yields trading at multi-decade highs. While the Bank of Japan, has intervened in FX markets at these levels in the past to stabilize the currency, it is unlikely to make further moves in the short run- a repeat of August 2024’s carry trade unwinds which saw a 12% decline in the Nikkei and global equity markets is unlikely as the central bank appears committed to forward guidance.

This volatility underscores a broader point: Fiscal uncertainty can amplify risk in FX markets.

Looking into 2026 and 2027 the U.S. faces a challenging fiscal landscape. Federal debt levels, already at historic highs, continue expanding as the administration implements the "Big Beautiful Bill"—an extensive package of tax cuts, infrastructure spending, and subsidies designed to revitalize domestic industry. While politically popular, the bill may worsen the fiscal picture, pushing federal debt toward levels that raise questions about long-term sustainability. This creates a paradox for investors: fiscal stimulus may boost short-term growth and support the dollar, but over the medium term, rising debt and fiscal credibility concerns risk undermining confidence in U.S. assets.

Currency markets face dual pressures. In 2025, the dollar has found some support in favorable yield differentials as bond markets priced in higher deficits and stronger nominal growth. However, by 2026 and 2027, the sustainability of these fiscal trends becomes questionable. If markets doubt Washington's commitment to fiscal judgement, the dollar could face structural headwinds, particularly if foreign investors start to demand even higher risk premiums for U.S. Treasuries. A situation we started to see this year.

The "Big Beautiful Bill" could potentially represent a near-term catalyst for U.S. dollar strength, but it is also a longer-term risk. Investors must carefully balance these forces: positioning for dollar appreciation linked to fiscal expansion while remaining alert to potential medium-term corrections as debt dynamics undermine credibility.

Outlook for 2026 and 2027

Investors should brace for a potentially prolonged period of volatility across major and emerging currencies. In the U.S., Fed policy risks becoming reactive to political pressure rather than purely data-driven, which may erode the dollar's predictability. The dollar will still likely maintain relative strength in 2026 as tariffs boost inflation and keep nominal yields elevated. By 2027, however, risks of fiscal strain, diminished Federal Reserve credibility, and persistent deficits could lead to dollar underperformance, especially against commodity-linked and reform-oriented currencies.

Europe and the U.K. will likely remain vulnerable to imported inflation, slower global trade, and the looming threat of Russia’s increasing military presence - limiting the upside potential for euro and sterling. The Chinese yuan will be managed weaker, but not in a disorderly fashion, as Beijing will continue to prioritize export competitiveness and its own deflation concerns. Mexico offers a more complex case: while tariff risk is negative, long-term foreign direct investment trends from nearshoring will support peso resilience once trade rules stabilize.

2026 will likely be a "dollar-up, volatility-up" environment, while 2027 may see the beginnings of a broader adjustment in which investors rotate toward alternative currencies and hard assets.

Hedging Strategies for FX Risk Managers

In 2026, FX managers should adopt a proactive currency risk management policy. For corporates with U.S. dollar liabilities and foreign revenues, forward contracts remain the most direct hedge, locking in exchange rates and providing budget certainty. Given the volatility we expect to experience in 2026, rolling three- to six-month forwards can balance flexibility with protection.

Options strategies—such as buying puts or using collars to hedge —offer asymmetric protection, giving investors and corporates upside participation, particularly in a climate where policy shocks can trigger outsized moves. For example, a U.S. importer concerned about peso volatility may pair forward hedges with peso call options to cap potential downside. Similarly, euro-zone exporters may prefer dollar call spreads to hedge against renewed U.S. dollar strength in 2026.

Portfolio managers should also consider diversifying exposure through multi-currency deposits, reducing reliance on a single currency pair. Incorporating gold and other commodities in their asset allocation plans can also provide traders with indirect protection against both dollar volatility and the risk of policy-induced inflation.

The 2026–2027 horizon presents traders with one of the most politically charged monetary environments in decades. With tariffs raising costs, a manufacturing base constrained by labor shortages, and a Federal Reserve facing unprecedented political interference, the dollar's trajectory will be volatile and, at times, counterintuitive. Currencies such as the yuan, peso, euro, and pound will remain subject to sharp swings as trade and policy uncertainty ripple through markets.

FX managers who combine disciplined hedging through forwards and options with diversified exposure will be best positioned to navigate this turbulence. The years ahead will require flexibility, and a disciplined approach to currency management.