Can King Dollar continue its reign?

Whether you think about your wealth in dollars, euros or krone, being aware of the currency allocation within an investment portfolio is an important part of meeting your wealth goals.

Weeks like last week remind us of that. Currency volatility has reached its highest level since May 2023 as investors contend with geopolitics uncertainty and recalibrate bets for the rate cutting cycle ahead. That mix made for the best week for the U.S. dollar (USD) in two years:

• Geopolitical uncertainty. Although it is the human impact that is our primary concern at this time, it is important to address the impact of developments in the Middle East on markets too. To that end, the impact on oil prices (which had their best week in more than a year) feels most intuitive. However, such events often spark a “flight to safety” for investors – where assets like the dollar and gold tend to benefit from inflows.
• The global cutting cycle. All in the space of a week, Fed Chair Powell talked down the prospect of another 50 basis point (bps) cut in November, a red-hot September U.S. payrolls report showed a resilient labor market, central bank heads in Europe (ECB and BoE) hinted at a faster pace of cuts, and Japan’s new Prime Minister suggested further rate increases weren’t needed for now. That improves the attractiveness of U.S. interest rates for global investors relative to other regions – driving the dollar higher.

But that is just one week. Looking at the bigger picture shows a broader USD downtrend starting to emerge since the summer. Indeed, before last week, it had been nine weekly losses in the previous ten weeks for the dollar. The moves have closely tracked swings in interest rates:

On the edge of a new dollar regime?

Despite the recent softness in the dollar, current levels still embed a 5-10% premium relative to what its historical relationship with interest rates would suggest. That will likely continue to unwind at some point over the coming years but, before we see that, we would argue that there are three necessary conditions for USD to weaken materially:

1. Certainty over Federal Reserve rate cuts.
2. Global (ex-US) growth improvement.
3. Positive risk sentiment.

The first condition looks to have been met by this point. The pace of cuts might not be so clear, but the Fed has clearly indicated its intention to lower interest rates to support the labor market as inflation risks fade.

There has certainly been progress on the two other conditions too, but the story is less clear-cut. Stimulus announcements from China boost the prospect for growth outside the U.S., but activity data generally remains weak (especially in Europe). And while risk assets have kept rallying this year to support higher-beta currencies against the dollar, the recent uptick in volatility poses risks to that trend.

Until we see more certainty over those conditions, it is difficult to envisage another leg lower for USD. At this point, that feels like it will be more of a 2025 story – particularly given the risks surrounding the upcoming U.S. Presidential election.

Considering how to diversify foreign exchange holdings ahead of that time could be prudent.

How we consider currency diversification?

The dollar is often considered the ballast for currency allocations, and rightfully so. It accounts for 60% of global foreign exchange reserves, 55% of banks’ foreign currency liabilities and claims, and makes up one side of 90% of all FX transactions. It is well and truly the global reserve currency.

However, the basics of investing tell us that you should not be putting all of your eggs in one basket. So how do we think about currencies in that context?

Each situation is different depending on an individual’s day-to-day spending needs. Naturally, those that live and pay taxes in the UK will need more pounds than a Danish farmer that hasn’t left their home country.

But from a pure diversification standpoint, we look to central banks as a starting point. Like many investors, central banks have very long time horizons, a primary objective to preserve purchasing power, and a priority for liquidity and safety while also seeking out some return. With nearly $13 trillion in assets under management, their bias is to overweight currencies with deep, liquid financial markets that have a large universe of investable assets. Their largest non-USD allocations are to securities denominated in euros, Japanese yen and British pounds, along with a few others for diversification purposes like the Chinese renminbi, Swiss franc, Australian dollar or Canadian dollar.