As market expectations grow for the Federal Reserve to continue cutting interest rates and adjust policy toward neutral levels, the US dollar has weakened persistently. Should political pressures further erode confidence in the Fed's independence, inflation expectations could rise, significantly depressing US real interest rates (real rate = nominal rate - inflation). This scenario might even force the Fed into yield curve control (YCC), amplifying downside risks for the dollar. This article analyzes the outlook for the dollar index and key influencing factors.
Fed's Dovish Policy Weighs on the Dollar Recent remarks by Trump targeting Hassett have reinforced expectations for a December rate cut, with markets anticipating the Fed will lower rates faster toward the neutral range of 3.00%-3.25%.
With the ECB expected to hold rates steady through 2026, eurozone investors' FX hedging costs for US assets may decline further. The three-month hedging cost has already dropped from 2.45% in July to 1.85% (annualized), with room for further decreases. Increased hedging activity will pressure the dollar, mirroring April's market behavior.
According to the ECB's latest financial stability report, eurozone investors held $3.8 trillion in US equities, $800 billion in US sovereign debt, and $1.5 trillion in other US debt instruments as of Q2 2025. Given bond investors' typically lower expected returns, this group is likely to drive higher dollar hedging ratios next year.
Studies show euro investors' optimal hedging ratio is approximately 66% (vs. 100%) to balance cost and risk—meaning a $1 million exposure would require paying 1-2.3% annually to hedge FX volatility.
Negative Real Rates Could Crush the Dollar If political pressure for Fed rate cuts intensifies, discussions about US real rates turning negative again will gain traction. The Fed's perceived independence has traditionally bolstered its inflation-fighting credibility; losing it could elevate inflation, forcing real rates higher artificially.
The two-year real swap rate has fallen from 2.5% in 2023 to just 0.75% currently. Any sign of the Fed cutting rates excessively could push real rates negative, sustaining dollar weakness. Historically, post-pandemic real rates at -3% triggered broad dollar selling. Should US real rates return to -1% by 2026, the dollar could drop 5-7% from current levels.
Yield Curve Control (YCC) as a Dollar Drag Research indicates when a country's 10-year yield exceeds nominal GDP growth, government debt tends to deteriorate—forcing central banks to intervene by buying bonds and cutting rates to flatten the curve. Such liquidity injections would devalue the currency internally and externally, pressuring the dollar index.
Bold Prediction: QE Could Reshape Dollar Trends Should the US Treasury and Fed agree on YCC implementation, renewed quantitative easing would heavily suppress the dollar. While printing money to control long-term yields might stimulate the economy, it would undermine dollar credibility and revive the post-financial-crisis "risk-on, dollar-weak" regime.
In a no-crisis scenario, the ECB and BOJ's balance sheets may appear more stable than the Fed's, potentially driving significant EUR/USD and JPY/USD outperformance. This framework could help the US government achieve dual goals: stabilizing financing costs and engineering dollar weakness.
Technical Analysis: The dollar index has broken below key levels at 98.36 and 99.194 (0.768 retracement from January's 110.17 peak). It now faces three critical resistance levels (including 99.07's 50% retracement) with only 98.87 as support, suggesting continued bottom-seeking consolidation before any rebound pattern emerges.
As of 17:00 Beijing time, the dollar index traded at 98.95.
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