The dollar stages a mini-comeback on debt-ceiling worries even as the Fed prepares to wind down its war on inflation

• The US dollar has rallied 2% over the past two weeks after starting 2023 with a long losing streak.
• Its gains have come despite traders expecting the Federal Reserve to end its rate-hiking campaign.

After a dismal start to 2023, the dollar has staged an impressive comeback over the past fortnight, paring most of its early-year losses.

The US Dollar Index – which tracks the greenback against a basket of six other currencies, including the euro and the Japanese yen – climbed over 2% in the space of two weeks, meaning the currency is now down just 0.1% year-to-date.

That rebound has come despite the widespread expectation that the Federal Reserve will soon end its aggressive tightening campaign, with inflation now cooling toward its 2% target.

Over 70% of traders believe that the central bank has made its final rate hike of this cycle, according to CME Group's Fedwatch tool – and when borrowing costs stop rising, a currency typically becomes less attractive to foreign investors who can find higher yields elsewhere.

And yet, the dollar's rebound defies that logic. Analysts say that the greenback's latest bout of strength is due to one crucial factor: the debt-ceiling standoff.

The Biden administration and the Republican-led House of Representatives still haven't found a breakthrough in talks to raise the US borrowing limit – and policymakers like Treasury Secretary Janet Yellen have warned that the government could run out of cash within two weeks.

While most investors believe that the two sides will come to an 11th-hour compromise as they did back in 2011, the specter of a disastrous default has Wall Street readying for a spike in stock-market volatility – and that's a boost for the dollar's "safe-haven" appeal.

The greenback is typically seen by investors as a place they can park their cash in times of turmoil, because it retains its value rather than plunging.

The dollar's climb over the past two weeks appears "to reflect increased safe-haven demand for the greenback due to concerns that the US government would run out of borrowing capacity unless Congress agreed to raise the debt ceiling," a team of strategists led by UBS's CIO Mark Haefele said in a recent research note seen by Insider.

But if the debt-ceiling standoff is resolved - in line with the latest comments from House Speaker Kevin McCarthy - then the buck's recent rally could soon rapidly fade, Haefele's team added.

"While political wranglings over the US borrowing limit have historically generated plenty of headlines, the impact on the US dollar has been fleeting," they said. "Currency markets are forward-looking and likely to assume Congress will agree to a last-minute deal."

So while the greenback is enjoying a brief rosy period for now, expect for dollar weakness – and all the worries that come with it – to be back soon.

Read more: Wall Street is bracing for stock market chaos as the debt-ceiling face-off drags on