‘King Dollar’ Challenged…But Not Vanquished

SUMMARY

• We believe the US dollar will maintain its reserve currency status.
• The path of least resistance for the dollar is likely down in the near-term.
• Dollar weakness is usually not a bearish sign for stocks, unless accompanied by recession.

Two summers ago, we wrote that we believed that the US Dollar (USD) “will maintain its reserve currency status for the foreseeable future.” In the midst of a difficult year for the dollar– with the US Dollar Index (DXY¹) dropping over -9% this year - do we still believe the dollar will remain the world’s preeminent currency for the foreseeable future? The answer is still ‘yes.’

While both valuation and technical factors suggest to us that the dollar may continue to weaken in the near-term, we would caution investors against reading too much concerning the US’ long-term economic stability into further dollar weakness. In our view, even another ~5-10% downside from here – as our technical support levels on DXY (red line on Chart 1, below) suggest as an eventual target - does not necessarily mean the USD’s ‘exorbitant privilege’ days as the world’s reserve currency are numbered.

In addition, while weakness in the dollar may exacerbate the inflationary impact on US consumers with regard to tariffs, it will also likely aid the corporate earnings of large publicly traded US exporters, the types of companies that dominate the S&P 500. Thus, on balance, we remain bullish on US stocks in the absence of a recession, which we don’t expect. In addition, foreign currency strength recently made us more constructive on international markets, leading to our upgraded view of stocks in Europe and Japan.

The Cause of Dollar Weakness Matters for the Stock Market

Analysis of why the dollar is dropping relative to foreign currencies contains important implications for investors. If the dollar is declining primarily due to eroding global confidence in the US economy and its’ institutions, this is an undesirable outcome that is likely negative for US stocks. However, if instead the dollar is declining largely due to the expectation of future easing from the Federal Reserve, along with weak-dollar political policy and the USD’s overvaluation to start the year on a purchasing power parity (PPP) basis, then this likely is a more benign scenario for stocks. Our current view is that it has been a bit of both this year… but concerns around the destabilizing nature of tariffs have been overblown and are now starting to recede.

It is no coincidence that the dollar’s weakness this year has occurred against the backdrop of President Trump’s dramatic attempt to minimize trade deficits via the widespread use of tariffs. Investor concerns around the potential negative growth and inflation ramifications of such a policy had stocks, Treasuries and the US dollar all dropping simultaneously in April – a rare event. However, since April a fair amount of the aggressive rhetoric around tariffs has been walked back, and the US has been making progress at the negotiation table with China and others. Stocks and Treasuries have largely recovered, with the dollar stabilizing somewhat.

On the policy side, we believe President Trump, Treasury Secretary Scott Bessent, and others are campaigning for a weak dollar…and thus far are getting their wish. For an Administration hyper focused on rebuilding US manufacturing capability and narrowing trade imbalances with other countries, this makes sense; a cheaper dollar makes US exports more attractive to foreign consumers. The dollar’s valuation has heretofore likely been a drag on exports; looking at real effective exchange rates² or ‘REER,’ the dollar’s large rise over the past 15 or so years has likely hurt US export competitiveness (see Chart 2, below).

While a globally coordinated, multilateral agreement among US trade partners to weaken the dollar (ala 1985’s ‘Plaza Accord’) is unlikely today given contentious geopolitics and trade dynamics, we believe the US is capable of unilaterally pressuring the dollar… through policies both intentional and otherwise. Trump’s harsh rhetoric towards Fed Chair Jerome Powell gives investors unwelcome flashbacks to the pressure that then-President Richard Nixon applied to Fed Chair Arthur Burns in the 1970s. A loss of political independence at the Fed or a meaningful ‘revenge tax’ on foreign holdings of US assets, if either were to occur, could cause foreign holders of US-denominated assets to decrease holdings…though we believe the Treasury market is still ‘too big to fail’, as we wrote about two weeks ago. In addition, the current House-approved version of the Administration’s ‘One Big, Beautiful Bill’ is likely a deficit-buster in the unlikely event it is enacted in full by the Senate (the non-partisan Congressional Budget Office estimates the House proposal would add over $3T to the deficit over the next decade, according to Bloomberg). However, we believe neither situation will end up in ‘worst-case scenario’ territory; we believe that the Fed will remain independent, and that the ultimate bill that will be passed will be moderated by deficit hawks in the Senate.

APPENDIX: Why We Still Believe USD Will Remain the World’s ‘Reserve Currency’ Despite Near-Term Headwinds

Since World War II, the US Dollar (USD) has served as the world’s preeminent ‘reserve currency’ – the means of exchange for most of the rest of the world to do business. From central bank holdings to international commerce and commodity transactions, the USD has served as the primary currency, commanding roughly 85% of the world’s foreign currency exchange (FX) transactions, according to forex.com.

For years we have fielded questions about how long the USD could maintain its reserve currency status, as threats emerged from both within (related to instability and high debt levels of the US economy) as well as abroad. Additionally, the steady drumbeat regarding digital currencies also has investors concerned that they may be missing a future reserve currency in its infancy. Is the dominance of the USD as the world’s ‘reserve currency’ set to end?

Don’t believe the hype: We believe that the USD will maintain its reserve currency status for the foreseeable future. Despite its high debt levels and political division, the US’s economic transparency, openness, flexibility, and governance suggest to us that our financial system is likely to remain at the center of global commerce. The US has problems like any economy, but potential contenders have more, as we will discuss. As Erasmus famously said, “in the land of the blind, the one-eyed man is king.”

It is Not Only About Who is the Biggest…But Also Who is the Most Trusted

Dollar skeptics point to the fact that China’s GDP is now larger than the US’s, at least in purchasing power parity (PPP). But when it comes to reserve currency status, sheer size is not everything. Bear in mind that the US became the world’s largest economy by GDP in 1916; yet reserve currency status for the USD did not really happen until after WWII.

Economists point to a mosaic of important factors for a currency’s reserve status outside of just size, including depth and openness of a country’s financial markets, ease of currency convertibility, rule of law, clarity around default resolution, the size and depth of government bond markets, and stability of domestic macroeconomic policies. By this rubric, we think so-called contenders such as the Chinese yuan fails the reserve currency ‘test.’

Despite its Flaws, US Still the Dominant Economic Force in the World, In Our View

We will be first to admit that the US has allowed its federal debt-to-GDP level to spiral upwards in recent decades to alarming levels. Deepening political dysfunction and embarrassing episodes such the constant self-inflicted debt ceiling ‘crises’ recently resulted in Moody’s becoming the third rating agency to remove the US AAA rating. These episodes are also a challenge to the USD's dominant stance with the international foreign exchange market (FX) community.

It is no wonder that global central banks have sought to diversify away from the USD with regard to foreign currency reserves, into large currencies like the Euro and smaller ones such as the Canadian dollar, the Australian dollar, and the Swiss Franc. However, despite it all, the US economy has proven itself to remain the most productive, flexible, and innovative of its kind in the world, in our opinion.

The Euro is arguably the closest thing the world has to a legitimate alternative to the USD; the Euro commands the second-highest share of worldwide transactions after the dollar (though it is a very distant 2nd). However, we would cite the Eurozone’s lack of a common Euro-wide government bond market as one significant drawback for potential reserves status, as compared to the ubiquity and ease of transaction for US Treasury securities. Furthermore, we believe the deep structural economic, demographic, political, and geopolitical issues facing Europe and north Asia make the Euro and Japanese Yen useful alternatives but no real threat to the USD’s dominance.

What about alternatives to fiat currency, such as gold or cryptocurrencies? There is not enough depth or liquidity in the physical gold market to replace the USD as the global reserve store of value, in our view. And in their brief history, cryptocurrencies have been much too prone to high price volatility to be relied upon as a store of value. Most importantly, crypto currently lives well outside the regulatory system, with few governments willing to recognize cryptocurrencies as legal tender, especially with their propensity to be utilized for extralegal ‘black-market’ purposes. In contrast, the US Senate’s recent ‘GENIUS’ bill to promote US dollar-backed ‘stablecoins’ (cryptocurrencies whose value is linked to the US dollar) may actually drive more long-term demand for US dollars, as dollars serve as stablecoin collateral.

Finally, there is military might. The US is a trading nation and, like Britain before it, controls the major oceans and thus critical trade routes. China would like to dominate the South China Sea but the major economies of the region outside China such as South Korea and Japan support the US Pacific Fleet’s role. Beyond the seas, the US is still the dominant global military force. The G7 countries from Europe plus Japan and Canada all seek the protection of the US in a crisis and their governments have not challenged the dollar’s status.

Conclusion: Dollar Could Drop Another 5-10% From Here… Without the US Economy or Stocks Falling Apart

We suspect the path of least resistance for the dollar will remain lower for the foreseeable future…a function of ‘Trumponomics’ policies colliding with a structurally overvalued dollar and difficult near-term technicals. However, this does not necessarily make us bearish on the prospects for the US economy, or for US stocks going forward. This suggests a recognition that both that the USD is expensive and may have more room to fall, as well as that a continued decrease in the currency could be a potential positive for US exports and export-oriented large-cap stocks. We remain overweight US equities relative to our policy benchmarks in our balanced asset allocation portfolios and have moved to a more neutral weighing in developed international stocks, in part because of a more constructive view on European currencies.

^{1 DXY is the symbol for the US dollar index, which tracks the price of the US dollar against six foreign currencies, aiming to give an indication of the value of USD in global markets.}

^{2 Real effective exchange rate (REER) - the weighted average of a country's currency in relation to an index or basket of other major currencies. These weights are determined by comparing the relative trade balance of a country's currency against that of each country in the index. An increase in a nation's REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper, reducing its trade competitiveness. (definition: forex.com)}

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.