As the war in Iran and wider Middle East conflict continues, we’re taking account of the impact on the US dollar across our currency portfolios. We believe the war’s impact on the dollar is likely to take place in two phases: dollar appreciation at first, followed by longer-term dollar weakness. 

Phase 1: Dollar strength

So far, the first phase has resulted in dollar appreciation. The war was a shock to markets, which were expecting another targeted US strike on Iran and a telegraphed response. Consequently, the market was happily buying risk and selling US dollars into the weekend before the war started. Contrary to expectations, the scope of the conflict took markets by surprise, particularly the effective closure of the Strait of Hormuz and the damage to energy production across the Middle East.

It quickly became clear that the conflict was a long volatility, long oil and short risk event, when the market was positioned the other way. We’ve highlighted previously that the US dollar is no longer a good hedge in global recessionary environments due to the large foreign ownership of risk assets, but there are two undeniable truths that are supporting the dollar in this phase: first, you need US dollars to pay for margin calls. And second, you need US dollars to pay for expensive oil. Given that the US has moved from an energy importer to energy exporter, it is relatively well insulated from the supply squeeze in petrochemicals.

So, while US assets were sold as the war started, the US dollar was not. As a result, US dollar short positioning was squeezed. The dollar was a good hedge, although the rally has been short and, at the time of writing, many other currencies are also close to flat or even higher than where they were before the war.

Phase 2: Dollar weakness

In our view, the second phase of the war’s impact on currency markets is likely to result in a weaker dollar. Our expectation is founded on three pillars.

First, we expect the dollar to weaken over time as the amount of global savings that are recycled into US capital markets falls. Second, we expect the dollar to be hit by rising risk premia due to policy uncertainty and a weaker security umbrella. And third, linked to concerns over US policy and security in the Middle East, there is a growing tail risk that oil is no longer priced in US dollars which would have significant ramifications for the dollar.

1. Lower global savings will be recycled into US capital markets

The US runs twin deficits – a fiscal deficit and a current account deficit. Ordinarily, this would result in a weaker currency, but as the world’s reserve currency the US dollar hasn’t suffered this fate because of huge capital inflows into the US. We estimate these flows need to be around $100 billion each month to offset the current account deficit and prevent the dollar from weakening.

To find out what has been driving these inflows, we need to look back to the period immediately after the Asian financial crisis in the late 1990s, when many Asian countries pivoted strongly towards exports to drive growth and build the currency reserves needed to prevent future crises. While this pivot provided a natural way for these countries to grow their economies after their currencies had experienced such steep depreciations, it also proved to be quite addictive. To keep their currencies cheap and industries competitive, earnings were reinvested into US dollar assets – primarily US Treasuries and Agencies – rather than converting into their local currencies, which would have seen their economies rebalance towards the domestic consumer as purchasing power improved.

After the global financial crisis, many countries doubled down on this strategy. China kept its currency cheap and then devalued in 2015, while austerity in Europe drove the euro weaker. An orientation towards exports drove the level of global savings higher, with much of this money finding its way into US capital markets, reducing risk premiums on bonds and equities. What’s interesting is that the flows into the US capital account have shifted from official sector buying of fixed income assets to private sector purchases of risk assets.

The result was that the rest of the world sold goods to the US, building up vast supply chain capabilities, while the US gave the rest of world claims on future revenue streams from its equity and bond markets. You’ll find plenty of academic debate on whether US deficits were to blame or whether they are the consequence of imbalances in exporting countries – but we are where we are.

Liberation Day showed what can happen when these flows stop. There was no net selling of US assets, the world just bought less of them, but the US dollar still lost 5% of its value in April 2025, stocks sold off aggressively and US Treasuries failed to act as a hedge, with the 10-year bond rising over 30 basis points before settling back to unchanged (and selling off again in May 2025).

The Iran war was another reminder that disputes between nations are increasingly kinetic. You need autonomy and/or leverage when multilateral organisations are no longer effective at enforcing the rules-based order of a neoliberal yesteryear. If a country gives you weapons, they may ask for them back if they need them. If a country needs oil, it will try to outbid the next country – it is no different from the global scramble for vaccines in 2021.

This all means, in our view, that we should see a significant increase in global spending. After all, what is the point of huge surpluses if you can’t defend yourself or power your grid. Defence spending will rise, stockpiling of key commodities will increase and countries will not want to be overly reliant on one security provider, so will look to hedge their bets. Rather than buying claims on US revenue streams, countries will be buying more hard assets. As the exorbitant privilege weakens, the US currency will need to do more work to bring the current and capital accounts into balance.

2. US dollar risk premia set to rise due to policy uncertainty and a weaker security umbrella

Other factors will also be at play in the second phase impacts from the war. For example, there is an argument that America’s pivot from soft to hard power, together with its more fractious relationship with allies who happen to be the biggest holders of US dollar assets, will mean the US gets a smaller portion of a smaller global savings pie.

Economic historian Barry Eichengreen delves into why countries hold reserves where they do, and breaks the reasons down into trade and security factors. The more you trade with a country, the more reserves you hold in that country’s currency. And the more that country offers you security protection, the more of their currency you hold.

In Ancient Greece, the Delian League was formed by Greek city states to protect themselves from Persia – it was a military alliance led by Athens, where members could contribute ships or money. Over time, it became easier to just send money and this funding led to Athens’s military dominance, and other city states were subsumed into the Athenian empire. It should be clear to today’s European and (some) Asian leaders that they have outsourced too much hard power and that their tributes to America’s capital account don’t count for much.

3. Rising tail risk that oil is no longer priced in US dollars

In 1974, President Richard Nixon and his Secretary of State Henry Kissinger came to an arrangement with Saudi Arabia - the kingdom would price oil exclusively in US dollars and in return the US would offer military protection. This deal cemented the US dollar’s position as the world’s reserve currency, as other countries needed dollars to buy oil, which in turn enabled the US to run persistent deficits.

This arrangement is the context through which one should view the UAE’s request for a swap line with the US, whereby the UAE can exchange dirhams for dollars (a facility only the European Central Bank, Bank of England, Swiss National Bank and Bank of Canada have access to). If reports are correct, the UAE has suggested it may need to price oil in other currencies if the US doesn’t grant its request. US Treasury Secretary Scott Bessent has said that numerous countries in the Gulf Cooperation Council (GCC) and some in Asia have made similar requests.

If the US doesn’t grant swap lines and GCC countries price oil (and perhaps other commodities) in other currencies, then countries around the world will have less need to hold US dollar reserves. Such an eventuality would result in significantly less US dollar demand and insert more risk premium in US dollar assets. However, if the US does grant swap lines, then the potential supply of dollars increases and there is less need for countries to hold US Treasuries outside of yield. In short, there is no good scenario for the US dollar.

Conclusion

Since the start of the current Middle East conflict, the US dollar has benefited from a positive terms-of-trade shock, a reversal of short positioning and a spike in volatility. But the dollar’s longer-term vulnerabilities have only been amplified by the conflict. Rather than buy claims on US financial assets, the world’s savers will be expected to direct more of their money into stockpiles of key commodities and into building up defence capabilities that are not reliant on a foreign superpower.

In order to rebalance its external position, the US will need to narrow its current account deficit and make its financial assets more attractive (in other words, cheaper) in foreign currency terms. Both actions will require a weaker dollar.

As a result of these pressures in currency markets, we remain strong proponents of underweighting the US dollar in portfolios, preferring to own currencies that perform well when commodities are rising and inflation is high, such as the Australian dollar, South African rand, Brazilian real and the Chilean peso.