Regime change: The implications of a US dollar bear market

Key takeaways

• The dollar's recent weakness reflects a combination of rich valuations, shifting interest-rate expectations and growing questions over the sustainability of US fiscal policy.
• If policymakers become less willing to allow bond markets to impose discipline through higher yields, the adjustment may increasingly be expressed through the currency instead.
• Currency exposure remains an important portfolio consideration, with equities offering a degree of natural protection while bond allocations require more deliberate management.

The US Dollar Index, which measures the dollar against a basket of major currencies, fell 9.4% in 2025, its worst annual performance since 2003. From its 2022 peak, the dollar has now declined by more than 13%. Whether this proves to be a cyclical setback or the start of a more prolonged structural adjustment remains uncertain, but the foundations underpinning the dollar’s long period of dominance appear less secure than they once did.

US Dollar Index – Typically follows multi-year cycles

Source: Bloomberg, W1M. Data as at 14 September 2026.

What's driving the dollar lower?

Initially, there were three main reasons behind the dollar’s decline.

First, interest-rate differentials were beginning to move against it. Investors had been rewarded for holding US assets because US interest rates were higher than those available elsewhere. As inflation moderated and monetary-policy paths started to converge, some of that advantage began to erode.

Second, the policy environment had become less predictable. The United States has historically enjoyed an institutional premium reflecting political stability, policy credibility and deep capital markets. While those advantages remain considerable, concerns around fiscal sustainability, policymaking and trade tensions have prompted some investors to reassess the premium attached to US assets.

The dollar remains the world’s dominant reserve currency and that status is unlikely to change anytime soon. Nevertheless, reserve diversification has continued. The freezing of Russia’s foreign-exchange reserves following its invasion of Ukraine demonstrated that reserve assets are not entirely politically neutral, encouraging some central banks to reduce their dependence on a single currency.

Third, valuation. Anyone who has travelled to the United States recently will have felt it: America has become an expensive place to visit. On a real effective exchange-rate basis, a broad measure of competitiveness across trading partners, the dollar entered this period from historically elevated levels. Even more informal measures, such as the Big Mac Index, tell a similar story. Valuation rarely determines the timing of turning points. However, expensive currencies require increasingly compelling reasons to remain expensive. When that support begins to fade, mean reversion can be powerful.

Taken together, these factors raised the possibility that the dollar’s weakness might represent more than a cyclical setback.

Composition of global foreign-exchange reserves (%total)

Source: Bloomberg, W1M. Data as at 14 September 2026.

A simple framework

Forecasting currencies is notoriously difficult. Exchange rates are influenced by everything from growth and inflation to politics, trade flows and investor sentiment. Rather than attempting to forecast every variable, we rely on a deliberately simple framework built around two questions: where can investors earn the most attractive returns, and how much confidence do they have in the country offering them?

• Interest-rate differentials: Currencies are highly sensitive to expected interest-rate paths. When one country’s central bank is expected to keep rates higher than its peers, investors are often drawn towards that market. This return advantage, known as “carry”, can support the currency. For much of the post-pandemic period, it was a significant tailwind for the dollar as the Federal Reserve raised rates faster and further than many other developed-market central banks.
• Country risk premia: Investors must also consider a country’s fiscal position, political stability and institutional framework. These factors influence the premium attached to its currency and assets more broadly, and can sometimes outweigh the benefit of higher interest rates. A high-yielding currency is not necessarily attractive if confidence in the underlying economic or policy outlook is deteriorating.

We are particularly interested in situations where these two factors point in the same direction. Applied to the dollar today, however, the message is nuanced. Interest-rate differentials do not provide a decisive signal, particularly following the resurgence in oil prices and the inflationary consequences of the Iran conflict. The more important question may be whether the premium long attached to US assets is beginning to change. Given the dollar’s position at the centre of the global financial system, the consequences would extend far beyond currency markets.

US Dollar Index vs 1y1y forward interest rate differentials

Source: Bloomberg, W1M. Data as at 14 September 2026.

A new twist: the Iran shock

The resurgence of conflict with Iran has complicated the picture. Oil prices have risen sharply, creating a terms-of-trade shock. Higher energy costs affect economies differently depending on their reliance on imported energy. Countries such as Japan and parts of Europe therefore face a different inflation and growth trade-off to the United States, which remains a significant producer and net exporter of oil.

As a result, the narrowing interest-rate differentials that initially weighed on the dollar may not evolve as smoothly as investors expected earlier in the year. Relative monetary-policy expectations have become more uncertain. However, the more interesting development may be occurring in the second pillar of our framework: the premium investors assign to US assets.

If not yields, then the dollar?

In our recent article on the “Bessent Put”, we discussed the growing willingness of policymakers to use an array of tools to limit upward pressure on long-term borrowing costs. These measures fall short of formal yield curve control. Nevertheless, they raise an important question; if governments become increasingly uncomfortable allowing bond markets to impose fiscal discipline through higher yields, where does the adjustment occur?

The pressure created by persistent deficits and rising borrowing requirements does not simply disappear. If yields are prevented from fully reflecting those pressures, investors may increasingly express them elsewhere.

One possibility is through the dollar. Fiscal concerns are often reflected through a combination of higher yields and a weaker currency. If policymakers are successful in limiting the adjustment through bond markets, a greater share of the burden may fall on the dollar instead. In this scenario, the currency acts as the release valve through which concerns about deficits, debt sustainability and policy credibility are expressed.

This does not imply the end of dollar dominance. The US retains the world’s deepest capital markets and the dollar remains the principal reserve currency. But it does suggest that conversations about de-dollarisation may be evolving into something broader: a reassessment of fiat currencies at a time when governments are becoming less willing to tolerate rising borrowing costs.

Equities: A natural hedge

A weaker dollar does not necessarily spell trouble for equity investors.

Many US companies generate a significant proportion of their revenues overseas. When the dollar weakens, those earnings become more valuable when translated back into US dollars. A softer currency can also improve the competitiveness of US exporters in international markets. Both effects can support earnings and, ultimately, share prices.

This creates an important difference between equities and many other asset classes. Currency weakness may reduce returns when translated back into sterling, but this can be partly or fully offset by stronger corporate earnings and share-price appreciation.

For that reason, maintaining unhedged exposure often makes sense within global equity portfolios. We focus on positive stock selection as the main driver of alpha over a three-to-five-year time horizon.

Bonds: Managing currency risk

Unlike equities, bonds have no natural mechanism through which currency weakness can be offset. A company may benefit from stronger overseas earnings or improved export competitiveness, but a bondholder simply receives their coupon and principal in a potentially weaker currency. Even modest currency moves can therefore overwhelm a year's worth of income.

For that reason, we generally avoid material FX risk where bonds are fulfilling a defensive role within portfolios. A fund structure allows investors to access a broader global opportunity set while efficiently controlling unwanted currency exposure through hedging.

The Waverton Global Strategic Bond Fund takes this a step further. Operating within the global unhedged bond universe, the fund can take active currency positions and has historically generated strong relative returns through FX allocation. Currency exposure is therefore not an unwanted by-product, but a deliberate potential source of alpha.

If the dollar is entering a more prolonged period of weakness, this flexibility could become increasingly important. While many bond investors view currency risk as something to hedge away, it may also prove one of the more attractive opportunities available within global fixed income over the coming years.

Multi-asset: A tactical tool

Within multi-asset funds, currency decisions form part of the broader assessment of macroeconomic risk rather than a permanent structural allocation.

As a rule, we hedge foreign-currency risk on fixed-income securities, while typically leaving the currency exposure arising from our allocation to non-UK equities unhedged. Alternatives are a mixed picture, with exposures displaying fixed income-like characteristics more likely to be hedged.

The team may also take active FX positions where valuations, interest-rate differentials or country risk premia create an attractive opportunity. These are tactical positions, sized according to their contribution to the risk and return of the overall portfolio and with reference to its existing cross-asset currency exposure.

The dollar at a crossroads

The dollar’s decline reflects a combination of rich valuations, changing interest-rate dynamics and evolving perceptions of US risk. While the Iran-driven energy shock has complicated the near-term outlook, the broader forces behind the move remain in place.

The more important question is where adjustment occurs if policymakers become increasingly reluctant to allow fiscal pressures to be expressed through higher bond yields. The “Bessent Put” may not be formal yield curve control, but it raises the possibility that market discipline is redirected rather than removed.

If borrowing costs are constrained, the adjustment may instead emerge through a weaker dollar, higher inflation expectations or stronger demand for real assets. In that sense, the dollar could become the release valve.

This is not a prediction of the end of dollar dominance. The US dollar remains the world’s reserve currency and enjoys advantages that are difficult to replicate. However, after more than a decade of strength, investors should at least consider the possibility that the dollar is entering a different phase of the cycle, one in which currency exposure becomes an increasingly important source of both risk and opportunity.

Glossary

• US Dollar Index: A measure of the dollar against a basket of major currencies, used to assess its broader strength or weakness.
• Interest-rate differentials: The difference between interest rates in different countries, which can influence where investors allocate capital.
• Country risk premia: The additional return investors may require to compensate for risks such as fiscal pressure, political uncertainty or policy concerns.
• Real effective exchange-rate: A measure of a currency’s value against trading partners, adjusted for inflation.
• Hedging: A strategy used to reduce unwanted risk, such as limiting the impact of adverse currency movements.