Recent indicators from the $9.5 trillion foreign exchange market suggest that investor and professional trader demand for the U.S. dollar is declining against the backdrop of a fragile cease-fire agreement between the U.S. and Iran. This trend signals that as global geopolitical risks ease, the demand for U.S. dollar funding in the currency swap market has notably weakened.
A key measure, the cross-currency basis, reveals that the additional cost investors pay or receive to obtain U.S. dollars outside the United States has continued to decrease in recent days. This indicates a steady reduction in dollar demand, particularly relative to the euro and the Swiss franc. "This is simply a reversal of the previous dollar trade," said Nathan Thooft, Senior Portfolio Manager at Manulife Investment Management. "During the crisis, the dollar was one of the few beneficiaries. Now, with signs of significant de-escalation, that buying pressure is reversing."
Recent media reports indicate that Iran's Deputy Foreign Minister, Abbas Araqchi, stated on the 10th that a consensus has been reached among parties, with Iran's ten-point plan serving as the basis for negotiations. He emphasized Iran's openness to diplomacy and dialogue but rejected talks based on misinformation aimed at paving the way for renewed military aggression.
However, while the cross-currency basis reflects weakening global demand for U.S. dollar cash, it is not a core forward-looking indicator for predicting the dollar's next move. Forecasting the dollar's direction remains a separate challenge, especially in a market highly sensitive to the latest war headlines and conflicting statements from U.S. President Donald Trump. "It is indeed difficult to anchor market consensus and portfolio positioning to a single macro narrative at the moment," noted Thooft, who is also Chief Investment Officer for multi-asset strategies teams managing approximately $309 billion in assets.
As illustrated, the recent trend toward a cease-fire in the Iran conflict and a looser funding environment are altering market demand for dollar swaps. Broadly, the cross-currency basis measures the extra cost of converting one currency into another beyond the level implied by cash market borrowing costs. It effectively determines the cost and price of foreign exchange hedging for global investors and serves as a symbolic indicator of capital flows between different economies and asset classes.
On Friday, the six-month euro basis narrowed significantly in favor of the euro, reaching levels not seen since early March. Similarly, the Swiss franc's related metric moved to its most favorable position in three weeks. These indicators had previously shifted rapidly in favor of the dollar six weeks ago when the U.S. and Israel began military strikes against Iran—signaling a surge in demand for dollar funding as escalating Middle East conflict dampened risk appetite in global financial markets.
"Headlines around the conflict have indeed calmed, which has helped boost risk sentiment and reduced the dollar's strength," said Jayati Bharadwaj, Head of FX Strategy at TD Securities.
Strategists at Nomura suggest that if the cease-fire holds and leads to a permanent reduction in hostilities, the long-term trend of de-dollarization could re-emerge. This scenario, driven by factors such as increasingly unpredictable U.S. policymaking and persistent fiscal deficits, could see broad selling of dollar-denominated assets. Under these conditions, the financial institution expects the U.S. dollar index to fall 4% from current levels by year-end.
The cross-currency basis is typically influenced by multiple factors, including geopolitical shocks, central bank monetary policies, and cross-border bond issuance. One factor this week is the easy funding environment, with continued strong inflows into short-term U.S. fixed-income securities indicating ample dollar liquidity and sufficient space for investors to park cash in short-term instruments.
Jack Boswell, a London-based FX Strategist at Wells Fargo, noted that the shift in the basis against the dollar shows "some return of risk appetite." However, he added that it is equally important to recognize that the European Central Bank and the Bank of England are reducing their balance sheets, in contrast to the Federal Reserve, leading to tighter funding conditions in Europe and the UK. This reflects "a fundamental change in the FX swap market," Boswell stated.
Comments