The United States has triggered a significant outflow of capital. This shift has primarily led to a weakening dollar and a surge in long-term Treasury yields, particularly for maturities between 10 and 30 years.
Over the past year, we’ve argued that any policy aimed at devaluing the dollar or undermining its status as the world’s reserve currency would ultimately harm U.S. businesses and consumers.
Assertions that the dollar is overvalued due to its reserve status—or that it would serve U.S. interests to end the greenback’s dominance—are misguided.
Such ideas, when translated into policies like the current tariff regime, are prompting large institutional investors and global central banks to de-risk their positions.
The belief that the U.S. could initiate a multifront trade war against both allies and adversaries without damaging the American economy and dollar-denominated assets was always flawed.
The current market stress stems from a private-sector balance sheet crisis driven by over-leveraged hedge funds, which is steadily draining liquidity from the system.
If this situation continues, a short-term stabilization program will be necessary to prevent a full-blown credit crunch and liquidity crisis. The Federal Reserve must prioritize financial stability by injecting liquidity into the market. At the same time, the administration should consider rolling back its tariff regime to protect the dollar and restore confidence in Treasuries.
It will likely take a generation to rebuild trust in the American economy and to reestablish the credibility of U.S. financial institutions. There’s historical precedent for such repair: think of the period following the collapse of the Bretton Woods system under the Nixon administration in 1973 and the near collapse of the global financial system in 2008.
A tipping point
U.S. equity markets have recently experienced significant declines, while bond and money markets are grappling with the dual pressures of a potential recession, rising inflation, and margin calls.
There’s an increasing risk that dollar-denominated assets will continue to unwind as the appeal of U.S. investments diminishes and the perceived safety of U.S. markets erodes.
The most visible indicators of this trade shock and global instability are the sharp declines across international stock markets. Since late March, Japan’s Topix index has dropped 12.3%, Germany’s DAX has fallen 13%, Canada’s market is down 8.6% since its January peak, and the S&P 500 has lost 12.8% since February.
This shock and resulting wealth erosion point to a critical turning point for the global economy.
More importantly, the traditional correlation between U.S. Treasury yields and the dollar’s exchange rate has broken down, leading to stark misalignments in the pricing of dollar-denominated assets, including Treasuries.
In these conditions, bid-ask spreads widen, and markets struggle to function correctly as liquidity evaporates. Price discovery collapses, creating “air pockets” where asset prices plunge. In Treasuries, such dislocations drive yields higher, which in turn feeds a negative cycle that weakens the dollar’s valuation and accelerates its decline.
In the near term, so-called “hot money” flows into U.S. financial assets are becoming less appealing. This trend would likely accelerate if short-term interest rates in the U.S. were forced to lower due to an economic recession. Over the longer term, the erosion of confidence in U.S. institutions could further discourage investment in the American economy.
Foreign direct investment (FDI)—purchases of 10% or more of a U.S. corporation’s stock—tends to represent more stable, long-term capital rather than short-term speculative bets. Since the recovery from the financial crisis, and particularly in the post-pandemic period, FDI has supported U.S. corporations, helping to strengthen the dollar.
A robust dollar has enabled U.S. households to afford foreign goods, kept inflation in check, and provided attractive returns for investors in dollar-denominated assets. However, the dollar index has already declined by 9.25% since the week before the January inauguration, signaling a shift in sentiment.
This wouldn’t be the first instance of the dollar weakening due to a loss of confidence in the U.S. government. A notable precedent was the dollar’s decline leading up to the financial crisis. That depreciation was followed by a period of austerity and political dysfunction, which kept the dollar fluctuating between $1.20 and $1.40 against the euro from 2008 to 2015.
Since 2015, the dollar’s strength has been supported by a robust U.S. economy that attracted both speculative “hot money” and more stable foreign direct investment into U.S. companies. This influx of capital helped the dollar stabilize around an average of $1.12 against the euro.
The dollar managed to hold its appeal, thanks in part to higher U.S. interest rates compared to other advanced economies and the strong performance of U.S. industries.
However, that support is now starting to fade as Europe and the U.K. lead the way with significant investments in infrastructure and defense.
The durability of the dollar’s strength ultimately hinges on investor confidence in the safety of dollar-denominated assets. In fact, the dollar has already slipped 10.9% against the euro since January 10, dropping from $1.02 to $1.15 by April 2. These moves have taken it above its $1.12 equilibrium level and its 10-year average.
The takeaway
Over the long term, while the dollar typically benefits from its safe-haven status during times of global uncertainty, it’s becoming increasingly uncertain that this status will endure indefinitely.
To maintain its position, the U.S. economy must continue to serve as both the consumer and lender of last resort, even as it navigates complex negotiations with trade partners and addresses challenges from geopolitical adversaries.
It’s essential to recognize that the trade deficit stems from domestic spending and saving behaviors—not from the dollar’s valuation or its role as the world’s reserve currency.
Neither the trade deficit nor the dollar’s recent overvaluation justifies sacrificing its reserve currency status through public policy. Such a move would risk a financial disaster comparable to when U.K. Chancellor Winston Churchill returned Britain to the gold standard in 1928, triggering a decade of deflation and unemployment.
The U.S. cannot expect to remain the centerpiece of the global economy if it retreats into isolationist policies.
Frequently Asked Questions
Is the U.S. dollar currently losing its global dominance?
There are signs of weakening, such as declining value against other major currencies and reduced foreign investment, but the dollar remains the world’s primary reserve currency.
What factors are causing the dollar to lose strength?
Rising U.S. debt, trade imbalances, geopolitical tensions, and shifts in global investment preferences are key factors putting pressure on the dollar.
How does U.S. monetary policy affect the dollar’s power?
Higher interest rates tend to strengthen the dollar by attracting investment, while rate cuts or aggressive stimulus can weaken it by increasing the money supply.
Does the trade deficit contribute to the dollar’s decline?
The trade deficit reflects the gap between U.S. spending and saving, but it alone doesn’t determine the dollar’s reserve status or long-term strength.
Can other currencies replace the dollar as the global reserve currency?
While alternatives like the euro, yuan, or cryptocurrencies exist, none currently match the dollar’s liquidity, stability, and widespread acceptance.
How does foreign direct investment impact the dollar’s value?
FDI inflows strengthen the dollar by signaling confidence in the U.S. economy and increasing demand for dollar-denominated assets.
What risks does a weaker dollar pose to the U.S. economy?
A weaker dollar can increase import costs, fuel inflation, and reduce purchasing power for American consumers.
Conclusion
While the U.S. dollar is currently facing challenges that have led to some decline in its value and influence, it remains the dominant global reserve currency. Factors such as rising debt, trade imbalances, and geopolitical shifts are testing the dollar’s strength. Still, its deep liquidity, broad acceptance, and the size of the U.S. economy continue to support its pivotal role. The dollar’s future power will largely depend on the United States’ ability to maintain economic stability, effective policy-making, and global confidence. Though alternatives are emerging, a permanent displacement of the dollar is unlikely in the near term, making it essential for policymakers to address underlying vulnerabilities to preserve its status for years to come.