A bleak year for the US dollar is drawing to a close with signs of stabilization, but many investors believe the currency’s decline will resume next year as global growth improves and the Federal Reserve moves further toward monetary easing.
The US dollar has fallen by about 9% this year against a basket of currencies (DXY), heading for its worst annual performance in eight years. The decline has been driven by expectations of interest rate cuts by the Federal Reserve, narrowing interest rate differentials with other major currencies, as well as rising concerns over US fiscal deficits and political uncertainty.
Investors widely expect the dollar to remain weak, as other major central banks keep policy steady or tighten, and as a new Federal Reserve chair takes office — a change that is expected to signal a more dovish tilt in the central bank’s stance.
The dollar typically weakens when the Federal Reserve cuts interest rates, as lower US rates make dollar-denominated assets less attractive to investors, reducing demand for the currency.
“The reality is that we still have an overvalued US dollar from a fundamental perspective,” said Karl Schamotta, chief market strategist at global corporate payments firm Corpay.
Determining the dollar’s path is critically important for investors, given the currency’s central role in the global financial system. A weaker dollar boosts profits for US multinationals by increasing the value of overseas revenues when converted back into dollars, and also enhances the appeal of international markets by adding a currency tailwind alongside underlying asset performance.
Despite the dollar’s recovery in recent months — with the dollar index rising by nearly 2% from its September lows — currency strategists have largely maintained forecasts for a weaker dollar in 2026, according to a Reuters poll conducted between November 28 and December 3.
The dollar’s broad real effective exchange rate — its value against a wide basket of foreign currencies adjusted for inflation — stood at 108.7 in October, only slightly below its record peak of 115.1 in January, indicating that the US currency remains overvalued, according to data from the Bank for International Settlements.
Global growth
Expectations of a weaker dollar hinge on convergence in global growth rates, with the US expected to lose some of its growth advantage as other major economies gain momentum.
“I think what’s different this time is that the rest of the world is going to grow at a faster pace next year,” said Anojit Sarin, portfolio manager at Brandes Global.
Investors expect fiscal stimulus in Germany, policy support in China, and improving growth trajectories in the euro area to erode the US growth premium that has supported the dollar in recent years.
“When the rest of the world starts to look better from a growth perspective, that tends to be supportive of continued dollar weakness,” said Paresh Upadhyaya, head of fixed income and currency strategy at Amundi, Europe’s largest asset manager.
Even investors who believe the worst of the dollar’s decline may be over say that any significant hit to US growth could pressure the currency.
“If there are any signs of weakness at any point next year, that could be bad for markets, but it would certainly weigh on the dollar as well,” said Jack Hare, investment analyst at mutual fund firm Guidestone Funds, who does not expect a major further dollar decline as a base case in 2026.
Diverging central bank policies
Expectations that the Federal Reserve will continue cutting interest rates, while other major central banks hold rates steady or raise them, could add further pressure on the dollar.
The deeply divided Federal Reserve cut interest rates in December, with the median of policymakers’ projections pointing to an additional quarter-point cut next year.
As Jerome Powell prepares to step aside ahead of the appointment of a new Fed chair by President Donald Trump, markets may price in a more dovish central bank stance next year, amid Trump’s pressure for lower interest rates.
Several leading and widely discussed candidates for the role — including White House economic adviser Kevin Hassett, former Fed governor Kevin Warsh, and current governor Chris Waller — have argued that interest rates should be lower than current levels.
“Even though the market is expecting limited movement from the Federal Reserve next year, we think the broader trend points toward weaker growth and weaker employment,” said Erik Merlis, co-head of global markets at Citizens in Boston, explaining why they are positioned short the dollar against G10 currencies.
By contrast, traders believe the European Central Bank will keep interest rates steady in 2026, although a rate hike is not completely off the table. The ECB left rates unchanged at its December meeting and revised some of its growth and inflation forecasts higher.
Not a straight line
Despite the longer-term outlook favoring a weaker dollar, investors cautioned against ruling out a near-term rebound.
Continued enthusiasm around artificial intelligence, and the resulting capital flows into US equities, could provide temporary support for the dollar.
In addition, support for US growth from the reopening of the government following this year’s shutdown, along with tax cuts enacted this year, could lift the dollar in the first quarter, according to Sarin of Brandes.
“But we tend to think that won’t be a sustainable driver for the dollar over the course of the year,” he added.
