SUMMARY
Contrary to many expectations, the US currency has weakened lately. We look for a potential bounce near term, followed by weakness later this year.
KEY TAKEAWAYS:
The US dollar has surprised to the downside recently
Excessive bullishness among some traders preceded the weakness
We look for a potential rally near term but further depreciation thereafter
It's fair to say that the “Trump trade” hasn’t played out quite as expected – at least not so far.
Various perceived beneficiaries of the US president’s second term in office – such as domestic small cap equities – have struggled in early 2025.
Likewise, the US dollar dropped by around 3% during the first three weeks of February. That was despite the new administration’s escalating tariff threats, which are widely seen as likelier to boost the “greenback.”
The reason for this is because tariffs could well raise US inflation, in turn keeping US interest rates higher, while also lowering the US trade deficit. Such forces are often associated with a strengthening dollar.
Another factor is uncertainty. Amid times of turmoil, such as a trade war, the most liquid currency in the world is often perceived as a potential “haven,” attracting inflows from global investors.
Drivers of dollar weakness
So, what has driven the dollar’s recent bout of weakness? And what might happen next?
Amid all the enthusiasm around the “Trump trade,” we think the dollar had become a crowded trade. Figure 1 shows how large speculators, such as hedge funds and institutional investors, have positioned in dollar futures contracts.
Figure 1. CFTC USD Positioning - Stretched longs have been pared back enough for now - unlikely they get pared back much more
Source: Bloomberg as of March 3, 2025. Indices are unmanaged. An investor cannot invest directly in an index. Index returns do not include any expenses, fees or sales charges, which would lower performance. They are shown for illustrative purposes only and do not represent the performance of any specific investment. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Past performance is no guarantee of future results. Real results may vary.
When the line is high, it means that the number of speculative long positions outnumber short positions. But what often happens when so many traders share a positive view is a snapback in the other direction.
Another cause of recent weakness may have been that markets had begun to doubt that the mooted tariffs would really come to pass, at least to the extent that had been threatened.
Dollar to “spring” higher?
As springtime nears in the Northern Hemisphere, we believe the dollar too might develop a spring in its step.
First, the US is likely to lay out its reciprocal tariff policy in greater detail in the March-April period. Admittedly, this is a less stringent approach than President Trump had originally hinted at.
Instead of blanket tariffs across the board, tariffs may be applied tit-for-tat in situations where the US administration believes that counterparts have acted unfairly.
Nonetheless, this could trigger market volatility, with the dollar potentially appreciating once more. Having gone as low as 103.76, the US Dollar Index could head back to 108 – 110
(The US Dollar Index measures the greenback’s value against a basket consisting of the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.)
We can even envisage an overshoot of 110 depending on how things play out.
In the case of the euro, we reckon the currency’s recent rally may have got ahead of itself.
Optimism over a potential Ukraine peace deal, European rearmament proposals and relaxation of Germany’s constitutional spending restraints helped bring this about.
At the same time, we don’t see the euro as fully pricing the tariff threat. So, further upside for now seems improbable.
Greenback weakness thereafter?
As the year progresses, the dollar may begin to look more vulnerable.
If potential US rivals invite retaliation from trading partners – as seems likely – the effects could be cumulative for the currency. The Trump administration’s bargaining leverage may also wane as targeted nations anticipate its moves.
Sooner or later, we expect the president to advocate more vocally for a weaker dollar, particularly if trade tensions hurt US economic growth. The combined effect of all this could be a weaker dollar over the medium term.
Federal Reserve policy will also play a part.
The US central bank has been reducing its holdings of bonds, which shrinks the supply of money in the system, supporting the dollar somewhat.
However, this process may come to a halt in June, intensifying downward pressure on the dollar.
Further Fed rate cuts also may be back in play. There is a risk that the US labor market weakens more than expected given the cuts currently being made to the federal workforce.
We see weakening risks as especially great against the Japanese yen, given that Japan’s central bank has been raising interest rates.
Embracing any near-term dollar upside too warmly seems especially risky, therefore.
