Is the U.S. dollar’s role in global finance challenged?

The heavy repositioning of investors away from U.S. assets this year has disrupted the “U.S. exceptionalism” playbook as well as long-term relationships. One such relationship has been the movement between the USD and bond yields. Despite rising U.S. bond yields, the USD has fallen along with U.S. equities. On a trade weighted basis, the USD is down 9% this year. Market theory and recent historical precedents would suggest that rising yields would boost the USD, as the carry becomes more attractive. Some attribute this recent divergence to investor concerns about U.S. policy outlook and its implications for the role of the USD in global finance.

Why the sad face?

The theory of the “Dollar Smile” suggests that the USD tends to rise during both strong expansions and recessions in the U.S. In periods of economic growth and rising earnings, the USD would strengthen as investors buy U.S. equities and other cyclical assets. Conversely, in times of market stress or looming recession, the USD would also rally as investors flock to safe haven assets, such as U.S. Treasuries. Only when there is a synchronized, robust global growth environment, such as in the 2000s, would the USD weaken as investors spread their portfolio allocation more broadly.

The various policy announcements from the current U.S. administration are clearly a headwind to U.S. economic activity, and the probability of a recession in the second half of 2025 has increased. However, the USD has declined as investors question the longer run outlook for the U.S. market and confidence in a currency which is built on a stable economy, the rule of law and an independent central bank.

Policy uncertainty is being reflected in other traditionally safe assets, as the longer end of the U.S. Treasury (UST) curve has risen even as the short end has declined. The spread between the 2 and 10-year and the 2 and 30-year UST has widened to 52 basis points (bps) and 100 bps, respectively, from 33 bps and 54 bps at the start of the year. 

Is the U.S. dollar really under threat?

With the USD behaving atypically, it is worth examining its current role in the global financial system.

For most other currencies, running both a fiscal and current account deficit like the U.S. would create a considerable amount of depreciation pressure on the currency. However, the USD’s unique position in the financial system helps shield it from this pressure. The recent depreciation may be a sign the shield is getting thinner.

It will still take some time for a challenger to the USD’s dominance to emerge, if at all, and this would require a sizeable increase in the asset base of other currencies. Seventy percent of foreign currency debt is denominated in USD, compared to 21% in euros and 3% in British pounds.

Where to from here?

In the near term, the USD is likely to remain under pressure and exhibit more volatility, due to both policy-related and market and economic factors. The USD remains overvalued on some metrics, with the real trade weighted exchange rate still over 1.6 standard deviations above its 10-year average and only slightly below its January 2021 peak.

Meanwhile, the revolving door policy on tariffs and the subsequent impact on the U.S. economy is likely to further erode the narrative of “U.S. exceptionalism” and keep investors looking for broader diversification in global equity exposure. A push for a weaker USD from the Trump administration in an attempt to boost U.S. exports competitiveness may mean the government finds a downward trend in USD movement acceptable.

High inflation is also a headwind to currency appreciation and the impact of tariffs on U.S. imports should lead to higher inflation in the U.S., but lower inflation in the rest of the world. This could happen if goods are rerouted away from the U.S. to other markets, lowering prices.

Furthermore, the growth impact of the tariff policy has materially weakened the U.S. growth outlook and raised expectations for easier policy from the U.S. Federal Reserve. The falling real yields that come from a combination of higher inflation and lower cash rates is potentially another drag on the USD.

Investment implications

We do not believe there is currently a viable replacement to the U.S. dollar in the global financial system. The near-term implications for the U.S. dollar still appear to be on the downside, unless there is a policy reversal on the implementation of reciprocal tariffs.

The U.S. trade weighted basket is dominated by the euro, the Japanese yen and the Swiss franc, and these currencies have appreciated by 10% this year. The performance of Asian currencies versus the USD have been positive, but much more muted given the growth risks from tariffs.

Investors should keep in mind the need to separate a weaker USD in terms of exchange rate movements and its role in global trade and the financial system. A weaker U.S. dollar does not necessarily equate to a reduced use of the currency. There have been times when the USD was much weaker, such as during the 2000s due to strong global growth, but the importance of the USD was never in doubt during that period.

For investors, significant currency shifts can lead to unwanted portfolio volatility, especially for those whose base currency is not the USD or who use it as a safe haven. The USD has not always worked as a safe haven, especially when risk events occur in the U.S., such as during the collapse of Silicon Valley Bank and the resulting banking crisis in 2023. While investors may hedge their defensive assets to manage currency volatility, it is worth considering by how much to extend hedging strategies to U.S. equity positions for non-USD investors.