The US dollar is still on the backfoot

It seems hard to envisage a way back for the US dollar. The market clearly does not like President Trump’s tariff strategy; the currency seems to have lost its safe-asset status, it remains significantly overvalued, while many US assets, notably stocks, also appear expensive compared to peers.

In addition, there remains this underlying view that the US Administration welcomes US dollar weakness as long as it does not significantly undermine the status of the greenback. Just as important is the fact that many of the US dollar’s peers are looking more attractive in their own right.

The euro, for instance, appears to be reinvigorated by more determined fiscal efforts to lift the eurozone economy. Of note here is the step up in defense spending across the region and the new German government’s decision to water down the much-maligned debt brake.

For its part, the yen has been reinvigorated by the Bank of Japan’s tightening of monetary policy. This has proved all the more influential for the yen, given that it is happening at the same time as others, including the Fed, are easing policy. None of this necessarily implies that the euro or the yen are going to replace the US dollar in any way, in terms of things like reserve use, trade invoicing or debt financing, but that does not really matter. The US dollar does not have to suffer this ignominy in order to lose value.

Steven Barrow, Head of Standard Bank G10 Strategy, thinks the bigger questions concern the length and extent of future US dollar weakness. On the former, he has argued many times before that the US dollar has tended to move in long-term cycles since the advent of floating rates in the 1970s. It is hard to say what drives these cycles. He pointed out before that they seem to be loosely related to the country’s political complexion, with Republican presidencies tending to see US dollar weakness with rallies under the Democrats.

If there is any economic context to this, it may be that Republican administrations have generally presided over poorer fiscal discipline; something that we may be seeing again as President Trump’s budget wends its way through Congress. These US dollar cycles have traditionally lasted anywhere from around five to ten years. The last one, which started in 2011 has lasted for a longer-than-average fourteen years, although Trump’s first term from 2017 through 2021 did see the US dollar move slightly lower, while the Obama and Biden presidencies on either side saw strong gains for the greenback.

“The ‘cycles theory’ might suggest that we are entering into a long-run downcycle that will last many years, if not a decade or more. When it comes to the extent of future dollar weakness, these cycles have regularly seen moves of 40%, or more, in the dollar’s trade-weighted value. That’s consistent with the euro up towards 1.60 in time or the US dollar/yen down to 85. Our longer-term forecasts do not predict this extent of US dollar weakness, although that may be in part due to the fact that we tend to look out just over the next year or more, and, as we said at the top, we feel that 1.25 for euro/dollar and 125 for dollar/yen is achievable”, said Steven Barrow.

One aspect of the US dollar’s weakness that is of help to many others is that central bank policy rates can be reduced without any fear that the move is going to undermine their currencies. Clearly this is of greater benefit to those central banks in emerging nations. But even in developed countries, the luxury of not having to ‘fear the Fed’ can pay dividends.

For instance, the ECB cut policy rates another 25-bps this Thursday. That will take the deposit rate down to 2%; a full 250-bps below the upper end of the Fed’s target range for the fed funds rate. But while this is a wide gap, we have to remember that the nominal rate gap is only one side of the equation determining the likely return from holding euros or dollars. The other side relates to risk; things like inflation expectations, budget concerns, policy credibility, and on each of these, the eurozone seems to have the upper hand at the moment.

In addition to this, we have to remember that the ECB will likely stop rate cuts soon, while the Fed will probably start to cut again. Hence, even if we consider the future outlook for policy it seems that the cards are stacked in favor of a stronger euro/dollar.