The dollar under Trump has suffered its strongest decline in half a century. This may not be the end

The year 2025 abruptly reversed the dynamics of the currency market: the dollar's exchange rate against the currencies of major U.S. trading partners, which had risen by 40% between 2010 and 2024, fell sharply. The first half of the year was marked by the strongest dollar depreciation in half a century, down 11% since 1973. In the following months, the nominal effective exchange rate recovered about a quarter of the decline, while the real exchange rate remained roughly flat at the end of the first half of the year.

It is possible that the dollar's weakening may continue, especially if US President Donald Trump's aggressiveness towards America's trading partners grows again. A 13.5% fall of the dollar against a basket of 10 currencies in his remaining presidential term, for example, is predicted by Stephen Jim, the author of the theory of the "dollar smile". The impetus for further weakening of the U.S. currency may also be a reduction in the interest rate of the Federal Reserve System.

This year, the trigger for the currency market reversal was the global trade war that Trump launched this spring. Usually, higher duties reduce demand for foreign currency (along with reduced demand for imports), and the exchange rate of the national currency rises, write Oleg Itzhoki (Harvard University) and Dmitry Mukhin (London School of Economics and Political Science). But this time the dollar behaved quite differently: it weakened.

This happened because it was difficult for investors trying to reduce American risks and diversify their investments to find suitable instruments. Therefore, they did not abandon dollar investments, but began to hedge them against the depreciation of the American currency. The growing demand for selling dollars on the derivatives market has led to a depreciation of the dollar in the spring-summer of 2025. Investors whose base currencies are Japanese yen and Swiss francs and, to a slightly lesser extent, euros, especially need such deals.

In previous years, investors actively hedged the risk of declining emerging market currencies, now there are more trades hedging against a falling dollar, which played a significant role in its weakening.

During the period of dollar weakening, unhedged investments in dollar assets can "eat up" all profits even in case of strong market growth. For example, an investor from the euro zone who bought U.S. stocks (from the beginning of 2025 to November 14, the S&P 500 index rose by 14.8%) would have lost almost 80% of his income due to the growth of the euro against the dollar (by 11.66% since the beginning of the year).

It is possible that the dollar has entered a long-term period of decline: in addition to trade wars and Fed rate cuts, it is pushed by the growth of the U.S. government debt and the cost of servicing it. There is no sane plan to reduce the budget deficit, and the debt problem hangs over the dollar like a sword of Damocles. This worries investors and reduces confidence in the bonds of the U.S. Ministry of Finance.

As of September 2025, spending on servicing the national debt (nearly $38 trillion) reached $1.2 trillion (17% of U.S. budget expenditures), and over the next 10 years is expected to grow to nearly $1.8 trillion. Currently, the U.S. Treasury spends only 3.16% of its debt service per year, but the growth of the debt and the increased need for refinancing could make it more expensive to service.

The main contribution to the growth of investors' uncertainty is the budget policy. In the coming years, the U.S. budget deficit will amount to 5-6% of GDP, which used to happen only during wars and recessions, economists of BNP Paribas note. The growth of the national debt, which is already about 120% of GDP, will provide a constant and growing supply of government bonds, but will reduce confidence in Treasury bonds, which for many years played in the financial markets as a "safe haven" - an asset that appreciates in value when the volatility of other assets increases.

In the spring-summer of 2025, investors began to doubt that the dollar remained a safe haven: it began to behave as a risky currency. In addition to the unpredictability of Trump's policy, this was facilitated by the decline over the past 20 years in the share of national banks among buyers of U.S. bonds and the growing share of hedge funds. These players have different strategies, so the volatility of Treasury securities is now higher during stressful periods.

A weakening dollar makes U.S. goods more competitive in global markets and assets less attractive to foreigners. Foreign investors now hold about $30 trillion in dollar assets (stocks and bonds), including Europeans - to the tune of about $8 trillion.

Morgan Stanley estimates that more than half of these European investments are not hedged: years of dollar appreciation have convinced investors that this will always be the case. Now they are beginning to hedge against a decline in the U.S. currency by making a counter deal to sell it (so hedging contributes to a further decline in the exchange rate).

The popularity of hedging is constrained by its high cost. On an annualized basis, protection against dollar depreciation against the euro costs about 2% of the hedged amount, and against the yen and Swiss franc - about 4-4.5%. But since the dollar may continue to decline, investment companies are increasingly recommending hedging this risk.

The U.S. is becoming more difficult to attract unhedged capital to finance the current deficit, analysts at Goldman Sachs wrote. But in the long term, the dollar remains overvalued (according to RBC Global Asset Management calculations, by about 15%). So while there are no signs of a decline in the dollar's international role, a new equilibrium would require a decline in its exchange rate or a cheapening of U.S. assets, or both.

For 15 years, the dollar's appreciation has increased the returns to foreign investors from investing in dollar assets and decreased the returns to Americans from foreign markets. If the dollar now enters a weakening phase, the situation will be reversed. This encourages investors to diversify their investments and reinforces the growth of emerging markets, which have been rallying this year.

The rest of the world's stock markets, except for the U.S., have gained almost twice as much as it has since the beginning of this year: 24.56%. And with a weakening dollar, American investors' returns would be close to 40%, which is a great incentive to diversify.

The inflow of investment in U.S. assets finances the current account of the U.S. balance of payments, which has been in deficit for half a century. This is the sum of the trade balance (the difference between exports and imports of goods and services) and the balance of payments to and from abroad (foreign tourism, migrant remittances, profits from international investments, etc.). The current account deficit is financed by investment inflows (direct and portfolio), while the surplus, on the contrary, finances outflows, when the citizens of a country invest more abroad than they receive from there. In the first half of the year, the current deficit was about 26% higher than a year earlier.

Over the many years of current deficits, the US has accumulated a gigantic negative net international investment position of 90% of GDP. It is possible that, corrected for measurement errors, this figure is actually about 67% of GDP, but it is also a lot. This means that U.S. liabilities to foreigners (stocks, bonds, dollar cash, equity stakes, etc.) exceed Americans' international assets (i.e., other countries' liabilities to them) by this amount.

A sharp, uncontrollable increase in the negative international investment stance has occurred in the last 5-6 years. It was triggered by an increase in the trade deficit and the increased attractiveness of the US equity market for foreigners. Until 2020, the current account deficit was expected to stabilize at 2% of GDP and the net investment position at around 50% of GDP. Instead, budget easing during the coronavirus pandemic increased the deficit to 4% of GDP. Net liabilities to foreigners at 90% of GDP is an unsustainable level calling for a correction.

But how to reduce the deficit investment position when it is based on "Americans' unique ability to turn physical capital and debt into assets the whole world wants to buy up," economists reasonably ask in the Peterson Institute for International Economics (PIIE) report on trade deficits and foreign borrowing. It is this ability that has provided a rising dollar and falling interest rates for the U.S. in previous years.

Based on this perspective, the high trade deficit that Trump would like to combat by raising duties is the result not of Americans' excessive demand for imports, but of the strong attractiveness of their markets to foreigners. For capital inflows into the U.S. to decline, it would take dollar investments to become riskier and less attractive. That is what is happening now.

It turns out that the economic problems of the United States are an extension of its advantages and exceptional position in the world economy. Large U.S. financial markets "vacuum up" capital in the rest of the world, leading to a stronger dollar, higher U.S. asset prices, and low interest rates (U.S. assets are perceived as safe). The constant inflow of capital allows the country to spend more than it earns, i.e., it finances trade and current account deficits.

That is why the constant deficits and debt do not create financing problems for the US. But America's central position in the global financial system may be shaken, and with it the "guaranteed" inflow of capital. At that point, the deficit and accumulated debt will become a problem from a privilege. By starting to tackle the trade deficit, Trump is "driving a wedge": he is making US financial markets less attractive.

U.S. dependence on foreign financing is very large and growing. Over the past 20 years, the share of foreign investment in U.S. bonds has remained relatively stable at around 25% (about $7 trillion), while in equities it has risen from 10.2% to 17.8% (to $18 trillion). The prospect of a weakening dollar means that the exclusive role of dollar assets as the most stable for investors will be increasingly called into question over time.

PIIE calculations show that in order to keep the international investment position at the same level, the current deficit should be reduced to 2.7% of GDP (in the first half of 2025 - 4.6% of GDP). To do this, the dollar must fall in value by 17-29%. A falling dollar increases the dollar value of foreign assets held by Americans, thereby reducing the investment deficit. So far, this program has been implemented only half or one-third.

For higher duties to reduce the trade deficit, they must reduce a country's negative international investment position, write Itzhoki and Muhin, who recently published a report on this. To pay off accumulated foreign debt, a country must either run a trade surplus or earn more from its overseas investments than foreigners earn in that country.

Trade policy affects asset prices and returns on international investment through currency fluctuations. This makes it difficult for the U.S. to pay its foreign debt because it is denominated in dollars. On the contrary, a weakening dollar improves the U.S. financial position (its debt measured in foreign currencies becomes smaller). Taking all this into account, Itzhoki and Muhin calculate that the import duty imposed by the US should be around 9%. Their model shows that, excluding such huge foreign liabilities, the optimal tariff could be 34%.

This article was AI-translated and verified by a human editor