HSBC's July warning about a potential 'explosive' U.S. dollar has materialized as the dollar index (DXY) fell 10.7% in the first half of 2025, marking its worst first-half performance in more than 50 years. According to HSBC's analysis, the reversal was driven by straightforward mechanical factors: the Fed cutting rates while running quantitative tightening since 2022, and global investors hedging dollar exposure amid tariff uncertainty. The investment bank had predicted this softness would continue through the second half, but warned of two scenarios where the dollar could stage a rally - a tariff-driven scenario creating forced dollar demand when importers need dollars to pay for goods, and a rate differential scenario if the Fed pauses cuts while other central banks ease.
The HSBC report's identified risk factors are now playing out in markets. The bank warned of a steepening U.S. Treasury impacting bond markets, which has materialized as investors face the risk of curve steepening if economic weakness pushes the Fed toward easing. Additionally, HSBC's warning of an unabated AI trade has proven prescient, with the bank noting that for many names at the forefront of the AI story in the US, expectations for full year 2026 earnings growth is flat or lower than the year-on-year earnings growth we have seen in the 12 months to Q2 2025. The bank also expected a reversal in the US Treasury market, as investors who started the year expecting yield curve steepening now face the risk of curve steepening if the economy weakens enough to push the Fed toward easing.
HSBC's analysis suggests that the pain trade isn't about predicting the dollar's direction, but recognizing that when everyone is on one side of the table, the mechanics of the reversal are what hurt. The bank expects an 'explosive' U.S. dollar in the second half of 2025, with hedge funds boosting bullish bets on the greenback to a 16-month high. HSBC noted that a stronger USD would be painful, but we see the 'pain trade' in the FX market taking the form of a more explosive period of USD strength. The bank warns that though positioning in flatteners may not be quite as crowded as steepeners were at the start of the year, we think curve steepening would now represent a pain trade for markets, as yields on two-year Treasuries have risen more than 60 basis points this year compared with about 20 basis points for 10-year yields.
HSBC also expects several other potential market surprises beyond the core dollar factors. The bank anticipates that a decline in yield in emerging markets may also surprise, as investors are expecting policy rates to go higher over the next three months, with a shift in preference for fixed income toward hard currency debt. Additionally, HSBC suggests that the idea of outperformance in European markets could also represent another pain trade, as Europe does not have the same AI exposure on a market cap basis as the U.S. or certain emerging markets, with the resurgence of US exceptionalism keeping European outperformance firmly away from consensus views. The bank warns that though positioning in flatteners may not be quite as crowded as steepeners were at the start of the year, we think curve steepening would now represent a pain trade for markets, as mechanical flows rather than policy optimism could drive dollar strength.
