Dollar in the Doldrums

Why there has been no bounce-back by the greenback, and what that implies for asset allocation.

The U.S. dollar Index is still 3.5% below its level on April 2, when President Donald Trump unveiled a list of “reciprocal tariffs” on U.S. trading partners. The dollar is down almost 8% so far this year. Over the past week or so, it has slumped particularly heavily against Asian currencies, with the focus on the Taiwanese dollar.

These recent dollar moves are notable, as they have happened while the S&P 500 Index has all but erased its losses since April 2. High yield bonds have retraced more than half of the spread-widening they experienced. While U.S. Treasury yields remain higher than they were before “Liberation Day,” they are down from their peaks, and their spread over swap rates, an indicator of stress in the market, has tightened. Implied volatility indices have returned to more normal levels.

If it weren’t for the dollar sell-off, April would look like yet another of those V-shaped market events that seem to have been common since the pandemic. So, what is dollar weakness telling us? How much further might it go? And what might this suggest for broader asset allocation?

Speculation

On the face of it, dollar weakness after April 2 is strange for two reasons.

First, higher U.S. tariffs would usually be expected to push up the dollar. If U.S. consumers buy fewer foreign goods, they will need less foreign currency. If they continue to buy those goods, inflation will rise and the Federal Reserve will find it harder to cut rates.

Second, for decades, risk aversion and market volatility have tended to be met with a stronger dollar, as investors sought the haven of U.S. assets.

It is possible that investors believe tariffs will hurt growth in the U.S. more than the rest of the world, and that this is outweighing their dollar-positive effects. But that is hard to square with the recovery in U.S. equities and high yield bonds.

Another possibility is that investors are buying the “Mar-a-Lago Accord” story. A play on the Plaza Accord in the mid-1980s, this theory implies that the U.S. administration’s real objective is to reshore manufacturing—and that such reshoring could be achieved with tariffs, if necessary, or more ideally by letting trading partners avoid tariffs in return for allowing their currencies to strengthen against the dollar.

The recent extraordinary rally by the Taiwanese dollar appears to have been caused, at least in part, by speculation that such a deal was being done behind the scenes. That speculation has met with official denials and, overall, the U.S. administration has been sending mixed signals about its dollar policy, making it hard to judge intentions.

Cross-Border Investor Flows

We think the dollar weakness is much more likely to be a symptom of cross-border investor flows.

Those flows may well be related to the outlook for weaker U.S. growth, but they can also be squared with the recovery in U.S. risk assets. U.S. risk asset prices can be pushed up as U.S. dollar investors rotate back into equities and out of Treasuries, but if non-U.S. dollar investors re-risk while staying outside of U.S. markets, there is no flow back into dollar assets. U.S. equities go up, but the dollar stays down.

This dynamic could be the source of the breakdown in the positive correlation between risk aversion and dollar strength. That correlation breakdown could, in turn, push the dollar down further, as non-U.S. investors may no longer see the dollar as a haven currency or unhedged dollar exposures as a source of diversification. As a result, investments retained in dollar assets may be subjected to higher hedge ratios, which would mean additional marginal dollar selling.

On top of all this, our Currency team notes that the dollar is still overvalued according to long-term metrics such as purchasing power parity—but also that dollar short positioning has become stretched. On balance, they see potential for another 3 – 5% of weakening against the euro and yen this year, but note that the next leg down is likely to come with more volatility than we have seen so far this year.

Be Mindful About How You Diversify

We think the dollar dynamics reinforce the case for balance and diversification, not least because the failure of the dollar to rebound with equities may be telling us something about lingering risks or hidden pitfalls. But the breakdown in the dollar-risk correlation is also a reminder that investors need to be mindful about how they diversify portfolios. A simple allocation to the dollar or U.S. Treasuries may provide less ballast than it used to, especially for non-U.S. investors.

A big part of the challenge is the stagflationary implication of both tariffs and dollar weakness. Our Fixed Income team observes that, rather than long-duration positions in U.S. Treasuries, long positions in U.S. breakeven inflation rates could be a solution for hedging risk in those conditions.

For some months, we have been arguing for diversification away from U.S. mega-cap equities. We anticipated outperformance from non-U.S. markets, but we also thought that many investors, wherever they are in the world, had become overexposed to the U.S.

Europe, in particular, looks increasingly attractive: It is less exposed than the U.S. to the inflationary effect of tariffs, and the weaker dollar that is inflationary in the U.S. is disinflationary in Europe. This gives Europe more flexibility to support its economy with fiscal spending and lower rates.

As well as advocating this regional diversification, we would now underline the importance of the currency exposures behind regional allocations. As we already mentioned, euro- and yen-based investors might now be more willing to incur the added cost of higher hedge ratios on the U.S. investments they retain given the dollar’s lower diversification benefit. By contrast, U.S. investors may wish to consider adding European and Japanese equities and bonds with lower or zero hedging, even though it would mean giving up some income from interest-rate differentials.

A Refresher Course in Balance

The remarkable decline in the dollar since the start of this year is an important part of the debate about diminished American exceptionalism (however one defines that term). That debate has a long way to go before we know whether, and to what extent, the dollar regime may be changing. The result is likely to be persistent uncertainty and volatility, which makes its own case for portfolio balance and diversification.

Tariffs, trade and broader U.S. policy aside, recognition among many investors that they had become overexposed to U.S. assets appears to have been one reason for the dollar sell-off, and the sell-off itself has been a timely reminder to those who remain overexposed. As we have written before, it is all too easy for portfolios to become unbalanced by accident, either by drifting gradually into excessive risk concentrations or because investors assume that historic correlations are permanent and immutable. The market will occasionally deliver a refresher course in genuine balance, as it has done with the dollar this year.