In a recent paper¹, we argued that sustained weakness in the US dollar would require clear evidence of narrowing real interest rate or growth differentials between the US and its major trading partners—conditions that have yet to fully materialise. Since then, the narrative around the weak dollar has continued to gain traction, but much of the perceived dollar weakness is actually a reflection of euro strength, which may now be overextended. Meanwhile, the US economy continues to demonstrate resilience, interest rate differentials remain supportive, and the dollar’s risk premium might be higher than warranted by underlying risks. Taken together, these factors might suggest a more constructive outlook for the dollar than current market sentiment implies.

The dollar index predominantly reflects euro strength, which now may be overextended

The narrative of a weakening dollar often overlooks the fact that much of the recent movement in currency markets has been driven by euro appreciation. Broader dollar indices, which include emerging market currencies, have only declined modestly from their peaks².

Some of the appreciation in the euro seems justified given that Germany’s recent approval of fiscal spending marks a significant shift in its traditionally conservative fiscal stance. The key question now is whether this spending will translate into productive investment that enhances the country’s supply-side capacity, or whether it will be constrained by structural bottlenecks.

Germany continues to face challenges such as labour shortages and bureaucratic inefficiencies, which could limit the effectiveness of the stimulus. If these constraints persist, the risk is that the additional spending may fuel inflation rather than drive real economic expansion. Furthermore, by front-loading a substantial portion of the spending, policymakers may reduce the urgency or political will to pursue more difficult and unpopular structural reforms.

At this stage, it remains too early to determine the outcome with confidence. What is evident, however, is that the euro’s recent strength appears increasingly out of step with underlying economic fundamentals. As noted in our earlier paper³, the euro area is still expected to only grow around 1% in 2025, with Germany nearing stagnation⁴—levels that would typically not support sustained euro appreciation.

Current level of the dollar suggests lower US real rates

The dollar’s performance is closely tied to cyclical factors including growth and real interest rates. The two are connected as interest rate differentials between countries generally reflect a difference in growth and inflation between economies, with stronger growth generally leading to higher interest rates. 

For the dollar to depreciate meaningfully from here, US real rates would likely need to fall materially relative to other core developed markets, either through lower nominal rates and/or a sustained rise in US inflation expectations. So far, 10-year TIPS (Treasury Inflation Protected Securities) yields remain around 2%⁵, and rate differentials continue to favour the US dollar – a signal the foreign exchange market appears for now to be downplaying.

Although some US Federal Reserve (Fed) officials have expressed openness to a rate cut, the broader tone of Fed communication remains cautious and data dependent. The expected drag to economic activity from higher tariffs—through reduced real disposable income and increased uncertainty—has not materialised in a meaningful way. Consumer spending remains robust, and business investment has not collapsed as feared. Meanwhile, the outlook for inflation within the Fed appears mixed, with some officials expecting inflation to rise in the summer from the impact from tariffs and others expecting inflation to steadily move towards target. Without a clear catalyst for easing, the dollar could find support from its yield advantage, particularly if other central banks remain dovish or begin cutting rates more aggressively. 

Policy risk and the case for a higher USD premium

While some survey-based indicators suggest a relatively flat US dollar risk premium versus the euro, valuation-based approaches show the premium is already elevated. Levels are now comparable to those last seen in late 2014, just before the ECB launched quantitative easing (QE).

Recent policy developments, including the “Big Beautiful Bill” raise questions about US fiscal sustainability but these concerns have been around for decades without significantly derailing the dollar’s broader trajectory.

More recently, investors have focused on the Mar-a-Lago Accord – an informal effort to rebalance global trade through unilateral US policy moves - as a possible source of higher risk premia. Some observers have likened this to a modern-day Plaza Accord (1985)⁶, but with a more unilateral and coercive edge. The goals may include: a weaker dollar to support domestic manufacturing; to reduce the US trade and (in theory) budget deficits; shift the defence and economic burden to allies under the US security umbrella; and extract more value from the US dollar’s reserve currency status.

Potential policies include:

• Tariffs to incentivise reshoring, reduce imports and as leverage tied to defence commitments.
• Currency realignment (pressure on surplus countries to revalue or a grand exchange rate accord).
• Debt restructuring (e.g. US treasury debt swaps).
• Capital controls (potentially restoring the pre-1984 withholding tax).

While these factors could justify a significantly higher risk premium on the dollar, the Trump administration’s partial rollback of its initial aggressive tariff measures suggests a potentially more pragmatic approach to policymaking—particularly when confronted with market volatility. This also seems to be the view of the market given that a higher risk premium is not price into other US asset classes.  US equities are holding up in local terms, while credit spreads are tight⁷. If this was a structural rejection of the dollar, we would expect a higher risk premium to show up beyond just the exchange rate.

Finally, it's important to note that despite somewhat controversial policy debates within the Trump administration, the US continues to benefit from its global safe-haven status. During recent geopolitical tensions—such as the Israel-Iran conflict—the dollar experienced renewed demand, highlighting its enduring role as a refuge in times of uncertainty. This dynamic reinforces the view that, despite market scepticism, the dollar remains the preferred currency when global risks escalate.