Typically, the US dollar is considered the ultimate safe-haven currency. This year’s sharp rise in both political and economic uncertainty should be a boon for the greenback. Yet, the dollar has not been behaving as expected, particularly in the wake of Trump’s bombshell reciprocal tariff announcement.
Why has the dollar sold off? And more importantly, is further depreciation likely?
At the start of this year, the US real effective exchange rate was at its highest level since October 1985 (see Exhibit 1). Although the dollar has sold off since, it remains around 15% to 20% above its long-term average.
The dollar has been supported by high US growth relative to the rest of the world, attractive foreign exchange (FX) carry, and strong relative performance of US equities in recent years. Going forward, we expect significant growth convergence between the US and other G10 economies. Under a more benign global scenario, it is quite plausible that over the next one to two years, both the US and eurozone economies will grow by around 1.5%. That would be a marked difference from the past few years during which the US economy consistently outperformed Europe by 1.5% to 2% per year. This convergence of growth will ultimately reduce USD's FX carry advantage. At the same time, given downside risks to global growth, we believe European currencies and the Japanese yen are likely to benefit more in the near term, including versus emerging market currencies.
Trump’s sweeping reciprocal tariffs could turbo-charge this growth convergence. When combined with other growth-negative policies, like aggressive immigration restrictions and government spending cuts, these tariffs increase the risk of a US recession materially.
We see several reasons why the recent selloff may extend to a full-blown dollar bear market. The US may be limited in its ability to offset the growth-negative impact of tariffs. An uptick in inflation expectations caused by tariff uncertainty is likely to keep the Federal Reserve on hold in the near term. Fiscal tools also may be limited given the US’s significantly larger government debt-to-GDP ratio versus its peers.
Meanwhile, developed market economies with lower government debt-to-GDP ratios have more fiscal room to offset the negative impact of tariffs. Additionally, foreign investors retain other tactical tools. Global investors are structurally overweight US asset markets after 15 years of US equity outperformance and USD appreciation. This imbalance is an additional source of vulnerability for the USD. Global investors have both economic and political reasons for reducing US allocations and increasing FX hedge ratios. These shifting dynamics will play out in the months and quarters to come. Other regime changes, like Germany’s massive defense and infrastructure spending plan, will unfold over the next decade, keeping US growth and dollar exceptionalism under pressure.
Paul Mielczarski
Head of Global Macro Strategy & Portfolio Manager
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