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.
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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.
Despite official statements against rapid currency depreciation in Japan and Korea, policymakers likely view a weaker currency as a beneficial stimulus. With negative output gaps and competition from China, the goal is not to reverse the trend but to manage its pace to avoid market disorder and US Treasury scrutiny.
A historical review places 2026 in the second-lowest decile for central bank rate activity (hikes/cuts). This data strongly suggests a contained FX volatility environment, as significant vol spikes historically occur only during periods of extremely high or low central bank intervention.
The primary risk for the U.S. is not the inevitable decline of the dollar's dominance, which could rebalance the economy. The danger lies in trying to fight this trend, leading to a disorderly and painful collapse rather than a graceful, managed transition from a position of strength.
Even if US inflation remains stubbornly high, the US dollar's potential to appreciate is capped by the Federal Reserve's asymmetric reaction function. The Fed is operating under a risk management framework where it is more inclined to ease on economic weakness than to react hawkishly to firm inflation, limiting terminal rate repricing.
The US dollar reached its peak global dominance in the early 2000s. The world is now gradually shifting to a system where multiple currencies (like the euro and yuan) and neutral assets (like gold) share the role of reserve currency, marking a return to a more historically normal state.
Each time the U.S. uses financial sanctions, it demonstrates the risks of relying on the dollar system. This incentivizes adversaries like Russia and China to accelerate the development of parallel financial infrastructure, weakening the dollar's long-term network effect and dominance.
The US dollar's rally has a natural ceiling because the government shutdown is withholding crucial growth and labor market data. Without this data, markets lack the conviction to push the dollar significantly higher, making the trend self-limiting.
Despite significant media attention, the Xi-Trump summit and other US diplomatic efforts in Asia had a muted impact on currency markets. The outcomes were either well-previewed by markets or structured to avoid immediate FX conversion flows, reminding traders that political headlines often don't translate into market events.
The US dollar's recent slide is not just due to a pro-risk environment. Markets are also pricing in the government reopening, which involves running down the Treasury General Account (TGA). This action is expected to inject significant liquidity into money markets, placing short-term downward pressure on the dollar.