A dismal year for the US dollar is ending with signs of stabilization, but many investors believe the currency’s slide will resume next year as the global economy rebounds and the Federal Reserve continues its easing policy.
The US dollar has fallen more than 9% this year against a basket of currencies, its worst performance in eight years, driven by expectations of interest rate cuts by the Federal Reserve, narrowing interest rate differentials with other major currencies and growing concerns about US fiscal deficits and political uncertainty.
Investors generally expect the dollar to weaken further as other major central banks maintain or tighten their policies and a new Federal Reserve chair takes over, a change that is expected to herald a more dovish tilt by the central bank.
The dollar typically falls when the Federal Reserve cuts rates, as lower U.S. interest rates make dollar-denominated assets less attractive to investors, reducing demand for the currency.
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“The reality is that we still have a fundamentally overvalued U.S. dollar,” said Karl Schamotta, chief markets strategist at global corporate payments company Corpay.
Getting the dollar’s trajectory right is crucial for investors, given the currency’s centrality in global finance. A weaker dollar boosts the profits of U.S. multinationals by increasing the value of revenue generated abroad when converted back to dollars, while making international markets more attractive by providing an exchange rate boost beyond underlying asset performance.
Despite the dollar’s rally in recent months — the dollar index is up 2% from its September low — currency strategists have mostly maintained their forecasts for a weaker dollar by 2026, according to a Reuters poll conducted from Nov. 28 to Dec. 3.
The dollar’s broad real effective exchange rate, that is, its value against a large basket of foreign currencies adjusted for inflation, stood at 108.7 in October, representing only a slight drop from the record 115.1 in January, indicating that the US currency remains overvalued, according to data from the Bank for International Settlements.
Global growth
Expectations of dollar weakness depend on the convergence of global growth rates, with the US lead expected to narrow as other major economies gain momentum.
“I think what’s different is that the rest of the world is just going to grow more next year,” said Anujeet Sareen, portfolio manager at Brandywine Global.
Fiscal stimulus from Germany, political support from China and improved growth prospects in the euro zone are expected to reduce the US growth premium that has supported the dollar in recent years, investors said.
“When the rest of the world starts to look better in terms of growth, that is favorable for the dollar to continue weakening,” said Paresh Upadhyaya, head of fixed income and currency strategy at Amundi, Europe’s largest asset manager.
Even investors who believe the worst of the dollar’s decline is over say any major hit to U.S. growth could weigh on the currency.
“If you see weakness at some point next year, that’s probably bad for the markets, but it could definitely hurt the dollar as well,” said Jack Herr, an investment analyst at fund firm GuideStone Funds, who doesn’t see a major dollar depreciation as his base case for 2026.
Central bank divergence
Expectations that the Federal Reserve will continue to cut rates, while other major central banks maintain or raise rates, could also weigh on the dollar.
The sharply divided Federal Reserve cut interest rates in December, with policymakers’ median view for next year indicating an additional cut of a quarter percentage point.
With Jerome Powell set to give way to President Trump’s upcoming nomination for Fed chair, the market could be anticipating a more accommodative central bank next year, given Trump’s push for lower rates.
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Several of the known finalists for the chair position, including White House economic adviser Kevin Hassett, former Fed Governor Kevin Warsh and current Fed Governor Chris Waller, have advocated for lower interest rates than the current ones.
“While the market expects limited action from the Federal Reserve next year, we think the trend is toward lower growth and lower employability,” said Eric Merlis, co-head of global markets at Citizens in Boston, who commented that they are “short” the U.S. dollar against other G10 currencies.
Meanwhile, traders consider that the European Central Bank will keep rates unchanged in 2026, although a rate increase is not completely ruled out. The ECB kept its policy rates steady at its December meeting and revised upward some of its growth and inflation projections.
It’s not a direct line
Despite the long-term outlook for weakness for the dollar, investors warned that a short-term rally in the dollar should not be ruled out.
Continued investor enthusiasm around artificial intelligence and resulting capital flows into US stocks could provide near-term support for the dollar.
The boost to US growth from the reopening of the government after this year’s shutdown and the tax cuts passed this year could push the dollar higher in the first quarter, Brandywine’s Sareen said.
“But we are inclined to think that this is probably not a sustained driver of the dollar during the year,” he commented.
With information from Reuters