Despite the potential for further weakness, the dollar's reserve currency status remains intact due to its trustworthiness and the lack of a viable alternative, among other reasons.
In 1H25, the U.S. dollar (DXY index) fell 10.7%, marking its worst performance for this period in over 50 years. Despite rate cuts by other developed market central banks like the ECB and BoE, the Fed has held rates steady, indicating that slower U.S. growth, rising deficits, policy uncertainty and changing global capital flows, rather than rate differentials, are driving the dollar weakening.
Let’s explore some recent dollar drivers below:
- Policy uncertainty: Sensitivity to headlines around tariffs and Fed independence has impacted the dollar. Comments about Fed Chair Powell's potential dismissal on July 16th led to a 1.2% drop in the dollar within an hour, though it has since rebounded. Lingering concerns may continue to exert downward pressure. Also, fiscal worries are rising due to the OBBBA’s $4.1T price tag and mixed revenue outlook. Policy and fiscal risks, along with elevated valuations, have prompted investors to reassess the large amount of USD-denominated assets they hold.
- Growth and rates: U.S. 2025 consensus growth estimates fell from 2.3% to 1.4% during March and April, though they have slightly recovered. Other regions also saw downward revisions, but the decline in U.S. growth expectations was more severe given previous optimism. The Fed has stayed on hold, but recent signs of economic weakening, particularly after July’s modest jobs report (+73k jobs), have increased rate cut expectations, potentially leading to further USD depreciation.
- Global capital reallocation: While long-term U.S. asset holdings remain strong, flows into U.S. equities have weakened significantly this year, with some months seeing outright selling, primarily by foreign individual investors. Non-U.S. domiciled ETFs investing in U.S. equities averaged net flows of $10.2B from Jan.-Jul. 2024 but only $5.7B over the same period in 2025. European investors, in particular, are allocating more to local assets, with European-focused ETFs domiciled in the region receiving a record $42B in net flows YTD as of July-end. This rebalancing trend, after years of exceptional U.S. returns, may continue to pressure the dollar.
Despite the potential for further weakness, the dollar's reserve currency status remains intact due to its trustworthiness and the lack of a viable alternative, among other reasons. While its share of foreign currency reserves, currently at 58%, may continue to gradually decline as some central banks diversify into assets like gold, it is far from being replaced. Also, the dollar continues to be the most-used and trusted currency for global transactions. However, this does not rule out the possibility of a prolonged dollar decline, similar to the 2002-2008 period, given its high starting value.
For investors, international equities and local currency bonds could continue to outperform. For U.S.-based investors, holding international currencies is crucial for diversification and enhancing equity returns during cycles of dollar declines, as demonstrated by the MSCI EAFE's 22% YTD return, with 10% attributed to a weaker dollar. However, it is crucial for investors to not go underweight U.S. assets and dynamic U.S. companies, especially those connected to AI trends.