Some analysts are talking about the end of dollar dominance. They primarily point to the erosion of international trust among trade partners and the high debt levels of the United States. A weakening appears to be on the horizon, they write.
For now, it’s too early to write off the dollar, though its peak may be in sight. What is keeping the dollar strong, and what could trigger its decline?
Measuring dollar strength—how is it done?
Various metrics are used in the media to express the value of the dollar. On one hand, there is the US Dollar Index (DXY), and on the other, the Real Broad Dollar Index. The difference between the two is significant. While the DXY Index is measured against six currencies (Euro 57.6 percent, Yen 13.6, Pound 11.9, CAD 9.1, SEK 4.5, and CHF 3.6), the Real Broad Dollar Index provides a much more accurate representation of the dollar’s trade strength, as it includes the United States’ main trading partners.
The Real Broad Dollar Index tracks the inflation-adjusted value of the US dollar since 1973 and can be followed through the Federal Reserve. The weightings differ greatly from the DXY Index (Euro 18.9 percent, CNY 15.8, MXN 13.5, CAD 13.3, Pound 5.3, KRW 3.3, and so on). This index is therefore much more relevant in the current debate on trade tariffs.
If we take the end of the credit crisis (mid-2011) as a starting point, we observe a dollar rally resulting in a nearly 40 percent increase—an impressive figure. What drove this sharp rise?
Two crucial factors
1. Outperforming US stock market (with the dollar in tow), attracting international investors
It goes without saying that the US stock market has continually gained appeal since the financial crisis: ultra-low interest rates, combined with a hyper-dynamic US investment environment (think SPACs, venture capital, the “Magnificent Seven”), attracted massive international investment capital to the dollar. By the end of 2024, US stocks had reached a post-1970 peak weight of 72 percent in the MSCI World Index and 65 percent in the broader MSCI ACWI.
The average annual outperformance of US equities over the past 15 years has been 5 percent (including a 2 percent hedging cost). Two key elements underlie this difference: higher earnings growth of +2.4 percent and a valuation increase of 3.8 percent. Strong US stock market results only drew more international capital and further pushed up the dollar.
2. US short-term interest rates
Since the end of 2014, short-term interest rates rose from 0.12 percent to 5.3 percent by the end of 2023. The ECB, by contrast, didn’t raise its short-term rate to 0.5 percent until July 21, 2022. It’s no surprise that the dollar’s exchange rate against the euro climbed from mid-2014 (1 euro = 1.13 dollar) to near parity by the end of August 2022. Interest rate differentials are a major driver of currency trends. The euro alone accounts for nearly 20 percent of the dollar’s rise (see its weighting in the Real Broad Dollar Index).
In my view, the strength of the dollar is largely the result of differing interest rate policies between the US and the rest of the world, as well as the strength of the US economy and stock market.
What’s next for the dollar?
We must therefore ask how these two indicators—interest rates and the stock market—will evolve in the coming months. Import tariffs generally lead to higher prices, a point that Mr. Powell has repeatedly emphasized and which underlies his cautious stance on interest rates. Even if tariffs result in one-time price increases, we now know that American consumers have negative memories of Covid-era inflation. The Federal Reserve is therefore likely to proceed cautiously and won’t hesitate to raise interest rates again if necessary. In the short term, this would support the dollar.
Over the medium term, however, import tariffs are harmful to growth. We are seeing increasing downward revisions to growth forecasts for the US (and globally). Uncertainty is detrimental to business investment. The future of the dollar—whether it declines and by how much—will therefore depend primarily on the two previously mentioned factors: US economic growth and the stock market. If a recession occurs and forces the Fed into steep rate cuts, this will come at the dollar’s expense. If poor stock market performance accompanies it, the dollar’s decline could be even more pronounced.
Of course, US technological dominance won’t disappear overnight. This brings us to the question of relative outperformance or underperformance in other regions. Can Europe continue its outperformance since the start of this year and attract more capital? Will China manage to boost domestic consumption in the coming months and breathe new life into its business sector and stock market? Or will the entire global economy slow down again, triggering a renewed flight to the dollar?
Conclusion
Two key factors that have supported the dollar in recent years are interest rates and the stock market. They will be crucial to its future trajectory. At the same time, we must not overlook what other central banks and countries are doing: diversifying away from the dollar. Central banks are buying more gold, emerging markets are conducting more trade in renminbi, and the Eurozone is waking up—potentially ready to carry more monetary weight in the coming years. And last but not least: China is on its way to becoming the next global superpower.
Anyone considering dollar-denominated bonds should keep all this in mind. Ample research shows that the additional interest compensation in foreign currencies at inflection points is often insufficient to offset currency depreciation. A modest degree of dollar diversification is therefore strongly recommended.
Jan Vergote is an independent financial consultant and analyst.