The US Dollar Index has faced renewed downward pressure since the beginning of 2026, with mainstream market interpretation attributing this to a structural loss of confidence in the US dollar, US Treasuries, and US equities. While the market appears almost uniformly bearish on the dollar, it was previously noted that Cathie Wood holds a bullish view. Additionally, a recent ING report on the US Dollar Index suggests the dollar may be stronger than anticipated. This analysis explores the possibility that, despite the decades-long global trend of gradual de-dollarization, the core driver of the current decline in the dollar index in 2026 may still be cyclical factors, rather than signaling a structural collapse of the dollar system.
Examined from a historical perspective, the current US Dollar Index is not in a genuinely "weak" phase. The true measure of the dollar's strength is its trade-weighted real exchange rate, adjusted for relative consumer price levels, not merely fluctuations in the nominal exchange rate. Federal Reserve data on the dollar's real exchange rate against 26 major trading partners shows that even after last year's correction, the cumulative 45% gain since 2011 remains largely intact. This context also explains last year's market discussions about the "Mar-a-Lago Accord" potentially suppressing the dollar, a period when Washington was attempting to use exchange rate policy to level the global competitive playing field for US manufacturing. Clearly, the dollar index remains within a historically high range. Should subsequent fundamental factors align, it still possesses significant room to fall, suggesting the current downtrend may have only just begun.
An adjustment in foreign investors' currency hedging strategies is a key factor driving the cyclical weakness in the dollar index from a capital flow perspective. Hedging operations by buy-side institutions have always been a core flow influencing forex market volatility. The episode in April of last year, where the dollar index fell sharply while US stocks and bonds showed resilience, brought cross-border portfolio hedging strategies into focus. Research from the Bank for International Settlements at the time highlighted the crucial role of Asian investors in this dynamic, although Fed Chair Powell expressed reservations about this conclusion. Previously high dollar hedging costs had been suppressing investor hedging ratios. Looking at EUR/USD hedging data specifically, institutions were generally under-hedged early last year, based on a consensus expectation that tariff policies would severely impact the currencies of US trading partners, leading to sustained dollar strength—a view that ultimately diverged sharply from the actual market performance. Data on hedging from Danish pension funds and asset managers, disclosed by Denmark's central bank, provides a rare window into buy-side behavior. This data showed a dollar hedging ratio of 72% at the end of last year, with the figure for January 2026 due in early March. Under baseline expectations, a policy divergence featuring 50 basis points of Fed rate cuts in 2026 against a steady ECB is projected to further compress dollar hedging costs, potentially pushing the year-end hedging ratio to 74%. This implies continued selling pressure on the dollar. However, a scenario where the hedging ratio surges to 80%-82% (over-hedging) is not currently part of the baseline forecast, as it would require a dramatic collapse in confidence towards the dollar, which is considered a low-probability event.
The dollar's safe-haven premium has also shrunk significantly, but this change appears cyclical rather than structural. The safe-haven attribute can be measured by the difference between the 3-month correlation coefficients of the Bloomberg Dollar Index with the S&P 500 and the 10-year Treasury yield. A more negative value indicates stronger dollar performance during equity market declines and rising long-term yields. Current data shows a -0.25 correlation between the dollar and the S&P 500. While this negative correlation is weaker than its historical average, it remains statistically significant, indicating the dollar's safe-haven status has not vanished entirely. Historically, the dollar index has periodically lost its defensive currency characteristics, so it is theoretically premature to label the current premium shrinkage as a structural shift.
Capital flow data indicates that foreign funds have not exited US assets, but their composition has changed notably. Private investors, accounting for over 80% of foreign holdings of US securities, remain the core support for US bonds and stocks. Their annual net purchases climbed from an average of $1 trillion per year ($88 billion monthly) during 2022-2024 to $1.5 trillion ($128 billion monthly) in 2025, primarily allocated to US equities, Treasuries, and credit bonds. As of September 2025, foreign investors' total share of US securities holdings is estimated at 20.2%, a near-decade high. However, a crucial observation is that holdings of US Treasuries have declined noticeably, while holdings of US equities have risen. This suggests that more conservative foreign capital may be receding due to concerns like exchange rate risk from heavy Treasury exposure, while the US AI narrative and strong stock market performance are attracting foreign risk capital. The retention of this capital is likely highly correlated with the performance of the US equity market. Foreign official investors (central banks, sovereign funds, governments) have largely maintained their US asset holdings since 2020. While their stance remains cautious, it marks a significant improvement compared to the减持 phase pre-2020, though their influence within the foreign holdings landscape continues to diminish.
From a global monetary system perspective, de-dollarization trends are observable, but the dollar's structural dominance has not been substantially eroded. Looking at core structural metrics for the dollar's role in global assets, liabilities, FX turnover, and cross-border settlements, some contraction has occurred since 2024 compared to 2026 levels. The latest IMF COFER data shows the dollar's share of global foreign exchange reserves was 56.9% in Q3 2025. After exchange rate adjustments, this was slightly higher than at the end of 2024, suggesting overall share fluctuations are often driven by valuation effects rather than active portfolio adjustments by central banks. In mid-2025, the dollar's share of turnover in the OTC foreign exchange market reached 86.8%. Adjusted for exchange rates, this share might see a slight rebound compared to 2024, but it generally remains weaker than 2026 levels.
The dollar's weakness could be a result of global capital reallocation. The core of "American exceptionalism" lies in the relative attractiveness of US assets compared to the rest of the world. Since the second half of last year, markets have begun pricing in the first synchronized global recovery following the impacts of the pandemic, the Russia-Ukraine conflict, and tariff shocks, leading to rising expectations for global economic resilience. Against this backdrop, recovering global risk appetite is driving capital towards pro-cyclical assets like emerging markets. Cumulative inflows into two leading emerging market equity ETFs have grown at their fastest pace in over a decade. This type of capital migration naturally weighs on the dollar index, representing not just fundamental dollar weakness but also the emergence of more attractive investment opportunities overseas.
For gauging future market direction, four key indicators warrant close monitoring to anticipate potential additional pressure on the dollar index from weakening foreign demand for US Treasuries: A widening of swap spreads, indicating foreign selling pressure pushing Treasury yields higher relative to SOFR; Significant steepening of the yield curve, particularly the 5s10s and 5s30s spreads, suggesting potential valuation dislocation in long-term yields; A sharp contraction in the indirect bidder participation at US Treasury auctions, confirming official sector selling pressure.
Despite the current dollar weakness being primarily cyclical, two potential triggers for structural selling require vigilance. Excluding an extreme scenario like US capital controls, the biggest risk this year pertains to Federal Reserve independence. If markets perceive the Fed is being forced into inappropriate rate cuts, the dollar could face panic selling, corresponding to a return to negative US real rates. The other core risk is the US fiscal position. Persistently high deficits combined with increased Treasury issuance could erode the core "safe asset" logic underpinning the dollar. If this coincides with continued declining foreign participation, the probability of a structural revaluation of the dollar index would increase substantially.
In summary, the baseline outlook for the full year 2026 remains bearish for the US Dollar Index. Declining short-term rates (expecting two Fed rate cuts within the year) are expected to drive continued hedging-related dollar selling. A projected slowdown in US economic growth in the second half, coupled with improving economic data from the Eurozone, should jointly pressure the dollar exchange rate. Ultimately, the dollar's weakness in 2026 is seen as a result of divergent global economic cycles, differing policy trajectories, and capital reallocation. The structural foundations of the dollar system are not yet shaken. Navigating the dollar index's fluctuations requires distinguishing between cyclical movements and structural changes, while accurately interpreting policy shifts and capital flow signals to identify investment opportunities.
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