Introduction to the Dollar’s Fate
Following President Trump’s April 2 speech, there were concerns that foreign investors were losing interest in dollar-denominated assets. This was due to the U.S. imposing widespread duties on its trading partners, leading to a decline in U.S. stocks, bonds, and the dollar. However, these fears have lessened as the U.S. stock market has reached record highs and U.S. Treasurys have rallied.
The Turnaround
The catalysts for this turnaround were President Trump’s decision to delay the implementation of reciprocal tariffs and the truce the U.S. reached with China to reduce tariffs. Despite this, the fate of the dollar is still uncertain. It depreciated by about 10 percent on a trade-weighted basis in the first half of the year, and many currency forecasters anticipate it will weaken further as the Federal Reserve eases monetary policy.
Reasons for the Dollar’s Decline
One reason for the dollar’s decline is that lower U.S. interest rates make U.S. bonds less attractive to foreign investors. Another reason is that lower interest rates reduce the costs of hedging dollars by reducing interest-rate differentials between the U.S. and foreign countries. The impact of currency hedging by foreigners on the dollar is highlighted by two recent reports. A study by the Bank for International Settlements concludes that the dollar’s slide in April and May was mainly the result of non-U.S. investors increasing their currency hedging activity.
Foreign Investors’ Perspective
A Deutsche Bank report found that beginning around mid-year, flows into dollar-hedged exchange-traded funds that buy U.S. assets have outpaced those into unhedged funds for the first time this decade. Deutsche Bank estimates that about 80 percent of the approximate $7 trillion of funds that have flowed into foreign-domiciled U.S. equity exchange traded funds over the past three months have been on a currency-hedged basis. This figure is up from about 20 percent at the start of the year.
Historical Context
Historically, foreign investors have held U.S. bonds to earn higher income than they could in their home markets. While they would hedge the currency exposure on bonds during periods of dollar weakness, they typically purchased U.S. equities on an unhedged basis. However, since the 2008 financial crisis, foreign holdings of U.S. stocks have increased more than five-fold to nearly $17 trillion as of mid-2024, whereas holdings of long-term bonds have doubled to $12.7 trillion.
The Role of U.S. Multinationals
Much of the appeal of U.S. equities to foreign investors stems from the dominance of U.S. multinationals, especially in technology. The tech sector accounts for about one third of the S&P 500 index versus 9 percent of the weight in the MSCI EAFE Index. In the past few years, foreign investors have mainly been attracted by the dominant role U.S. multinationals have played in the realm of artificial intelligence.
Concerns about the Dollar
The principal reason foreign investors are concerned about the dollar is that they view it as vulnerable due to its relatively high value compared to the past two decades. Furthermore, interest rate differentials favoring the dollar are likely to narrow as the Fed lowers interest rates. In that event, the weakening of the dollar would be benign if lower U.S. interest rates are accompanied by falling long-term bond yields and higher stock prices.
Risks and Uncertainties
However, there is a risk that the dollar’s depreciation could trigger a loss of investor confidence at some point, leading to a sell-off in stocks and bonds. The main factor preventing a full-blown crisis was Trump’s decision to put Treasury Secretary Scott Bessent in charge of trade negotiations, which helped calm investors’ concerns. In comparison, one factor that could cause a loss of investor confidence now is the pressure the Trump administration is putting on the Federal Reserve to lower interest rates when inflation is nearly a full percentage point above its 2 percent target.
Conclusion
In conclusion, the fate of the dollar is still uncertain, and its value may continue to decline as the Federal Reserve eases monetary policy. Foreign investors are increasingly hedging their currency exposure, and the dollar’s vulnerability is a concern due to its relatively high value. While the U.S. stock market has reached record highs, there is a risk that the dollar’s depreciation could trigger a loss of investor confidence, leading to a sell-off in stocks and bonds. Ultimately, the dollar’s fate will depend on various factors, including the Federal Reserve’s actions, trade negotiations, and the overall health of the U.S. economy.
