Global demand for dollars as the reserve currency forces the U.S. to run persistent trade deficits to supply them. This strengthens the dollar and boosts import power but hollows out the domestic industrial base. A future decline in dollar demand would create a painful economic transition.

While U.S. fiscal deficits remain high, new tariffs are reducing the trade deficit. This means fewer U.S. dollars are flowing abroad to foreign entities who would typically recycle them into buying U.S. assets like treasuries. This dynamic creates a dollar liquidity crunch, strengthening the dollar.

Contrary to its goals, the U.S. trade war has resulted in self-isolation. Data shows the U.S. is the only country buying less from China, while U.S. allies and developing nations have increased their trade, leading to a record $1 trillion surplus for China. This highlights a strategic miscalculation in U.S. foreign trade policy.

A weakening dollar reduces the credit risk for dollar-borrowers, which encourages more dollar-denominated lending. This credit is the lifeblood of intricate global supply chains. As a result, exports of sophisticated goods, like semiconductors, can thrive even during periods of dollar weakness.

The U.S. dollar's decline is forecast to persist into H1 2026, driven by more than just policy shifts. As U.S. interest rate advantages narrow relative to the rest of the world, hedging costs for foreign investors decrease. This provides a greater incentive for investors to hedge their currency exposure, leading to increased dollar selling.

The negative economic impact of tariffs was weaker than forecast because key transmission channels failed to materialize. A lack of foreign retaliation, a depreciating dollar that boosted exports, and a surprisingly strong stock market prevented the anticipated tightening of financial conditions.

Officials at IMF meetings expressed surprise at how little the Trump administration has focused on foreign exchange rates. There is a growing expectation that this could change next year, with a renewed focus on the dollar if the US trade deficit fails to normalize, creating a latent political risk.

For decades, a tacit global agreement existed: the U.S. buys the world's goods and provides security, and in return, the world finances U.S. debt by buying Treasuries. As U.S. policy shifts towards protectionism and reduced global policing, other nations may no longer feel obligated to fund U.S. deficits, pushing borrowing costs higher.

The combination of restrictive trade policy, locked-in fiscal spending, and a Federal Reserve prioritizing growth over inflation control creates a durable trend toward a weaker U.S. dollar. This environment also suggests longer-term bond yields will remain elevated.