If US policies turn out to be inflationary and destabilising, the dollar is likely to lose its positive diversification effects in the future.
For European investors, US dollar strength has been a near constant tailwind to US asset performance since 2010. On top of the strong performance of the assets themselves, US dollar appreciation has added an additional 2.4% per annum for euro investors, and 1.9% per annum for sterling investors, to the returns from US stocks and bonds.
However, this year has been different. The aggressive trade and fiscal policies of the new US administration have weakened the dollar and, as we highlighted in our recent piece A new path for the US dollar, that weakness might have further to go.
To hedge or not to hedge?
Due to the outperformance of US assets, dollar exposure has increased significantly in many portfolios. The USD proportion in a classic 60:40 portfolio comprised of the MSCI ACWI and the Bloomberg Global Aggregate Bond Index increased from 41% at the start of 2011 to 55% at the end of May 2025, according to data from Bloomberg and MSCI.
From a portfolio management perspective, investors need to pay more attention to currency exposure across asset classes. Despite this year’s depreciation, the US dollar is still fundamentally a very expensive currency. Based on our 2025 Long-Term Capital Market Assumptions (LTCMA), we estimate that the US dollar is still 13% above fair value versus EUR, and 10% versus GBP. The key question for investors is how orderly a dollar decline could be.
In our base case of a US economy that slows but avoids recession, the dollar would likely depreciate in an orderly fashion in the coming years against most of its peer currencies. Hedging strategies may look unappealing in this scenario given relatively high hedging costs (see Exhibit 24). Small and orderly declines in the dollar might not warrant paying for such insurance.
However, there are disorderly dollar scenarios that would make this insurance a price worth paying. Chief among these risks are a re-escalation of the tariff war, fiscal largesse and policies that challenge Federal Reserve independence or coerce foreign investors into buying super long-term bonds at a yield discount (a so-called Mar-a-Lago Accord that is being discussed in some circles).
Carry trade stutters as hedging costs rise
On the fixed income side, the USD carry trade has lost appeal. As interest rates have risen in many geographies, there is no longer a yield pickup in US Treasuries on a currency-hedged basis (see Exhibit 25). Therefore, international investors can only take advantage of relatively high US nominal yields if they are willing to take currency risks. The deteriorating fundamentals of the US dollar make this option now increasingly unattractive.
Interest rate normalisation in Japan is an important component of the story and European investors should be particularly mindful of the risks of getting caught in the midst of capital flows between the US and Japan. Japanese investors hold more than $1.1tn in Treasury securities and are currently the largest foreign holder of US Treasuries. As Japanese headline inflation remains stubbornly above 3%, the Bank of Japan is expected to tighten policy going forward and longer-term JGB yields have reached all-time highs.
Japanese investors who desperately looked for income in the decades of deflation and low yields now have less incentive to move abroad to generate income. The global carry trade fuelled by cheap yen financing is stuttering. From a European perspective, as dollar headwinds intensify, a higher allocation to domestic bonds seems to be justified from a risk/return perspective.
A possible headwind for total equity returns
Since the end of Bretton Woods, a strong US dollar was usually accompanied by the outperformance of US equities relative to the rest of the world (see Exhibit 26). In periods of dollar weakness, the contrary was true. This is intuitive since the attractiveness of equity returns attracts global capital and drives movements in the dollar.
As highlighted in our equity chapter, the prospects for US earnings growth remain attractive but highly dependent on both economic resilience during a period of heightened uncertainty and future tech performance. On the other hand, the shift to more active fiscal policy in Europe bears the promise of better growth and returns in the coming years, which could divert some portfolio flows back across the Atlantic.
Investors should therefore be mindful of unhedged exposures and how currency moves have the potential to compound any relative underperformance should the US stock market falter. The first five months of 2025 are a reminder that, in the short term, these swings can be significant. In local currency terms, the S&P 500 was up 1% to the end of May, while for unhedged investors in EUR and GBP the index was down 8% and 6% respectively.
Our 2025 LTCMAs estimate a fair value for USD to EUR (GBP) of 1.29 (1.48) by 2037. This implies a 1.1% (0.8%) depreciation for the USD per year. Given the expectation of converging short-term yields between currency pairs in the coming years, strategic hedging looks increasingly attractive in a long-term context. In the short term, current hedging cost are a significant handicap to overcome, but adding dollar-hedged equity strategies can provide some protection against policy mistakes and disorderly depreciation.
The safe haven dollar premium may not be what it was
Over the last decade, investors may have been willing to have a larger dollar exposure for the additional protection it afforded them in times of market volatility. Since the height of the global financial crisis, the rolling two-year correlation of the greenback to the performance of the S&P 500 has been almost continuously negative. This meant that US dollar exposure could offset some equity risk. This was particularly evident for crises that occurred outside the US, such as the euro sovereign debt crisis and the outbreak of the Ukraine War.
However, that safe haven status no longer seems as solid. The US dollar’s correlation with the stock market has been growing sharply for six months. If US policies turn out to be inflationary and destabilising, the dollar is likely to lose its positive diversification effects.
Being mindful of the right balance of currency risk in the portfolio is crucial for future investment success. The addition of currency-hedged strategies and a currency overlay, as well as broad international diversification may mitigate the risks of both more orderly and disorderly dollar declines.