Dollar starts 2026 on front foot after biggest annual drop in eight years

LONDON, Jan 2 (Reuters): The US dollar made a positive start to 2026 on Friday after struggling against most currencies last year, while the yen inched back towards a 10-month low as traders awaited US economic data to predict interest rate moves this year.

A narrowing interest rate difference between the US and other economies cast a shadow over markets last year, resulting in sharp gains against the dollar for most major currencies, with the exception of the Japanese yen.

Worries about the US fiscal deficit, a global trade war and concern about Federal Reserve independence took a toll on the greenback, and those issues are likely to linger into 2026.

Markets in Japan and China were closed on Friday, making for light trading volume and little movement.

"Market liquidity should improve next week alongside a fuller data slate," said Jens Naervig Pedersen, FX strategist at Danske Bank.

Data in focus

The euro was down 0.2% at $1.1725 on the first trading day of the year, as euro zone manufacturing activity fell in December to its weakest in nine months, a survey showed. The currency surged 13.5% last year, its biggest annual rise since 2017.

Sterling last bought $1.3439 following a 7.7% increase in 2025, also its biggest yearly jump since 2017.

The dollar index , which measures the U.S. currency against six other units, was up 0.2% on Friday at 98.44 after registering a 9.4% decline in 2025, its biggest drop in eight years. Economic data including U.S. payrolls and jobless figures are due next week, providing clues on the health of the labour market and where the Fed's policy rate may end up this year.

Much of the focus at the start of the year will be on whom U.S. President Donald Trump chooses to be the next Fed chair as the term of current head Jerome Powell ends in May.

Trump flagged that he would make his Fed chair pick this month, with White House economic adviser Kevin Hassett the current favourite on betting site Polymarket, opens new tab.

Investors are bracing for Trump's pick to be more dovish and cut rates, as the president has repeatedly criticised Powell and the Fed for not lowering borrowing costs more swiftly or deeply.

Traders are fully pricing in two cuts this year compared to one projected by a currently divided Fed board.

"We expect that concerns around central bank independence will extend into 2026, and see the upcoming change in Fed leadership as one of several reasons why risks around our Fed funds rate forecast skew dovish," Goldman strategists said.