The dollar’s free lunch era is over
Lower returns and higher risk mark a change in dynamics for the US currency, writes Aaron Hurd, senior portfolio manager, currency group, State Street Investment Management.
Investors in currency-unhedged US dollar assets have enjoyed a long period of higher returns and lower risk. But the dynamics have flipped to lower returns and higher risk in 2025, and we believe that will persist.
The dollar has enjoyed a near 15-year-long bull market that saw the US Federal Reserve’s broad trade-weighted dollar index rise over 45%. For much of this period the dollar also enjoyed historically negative correlations to risky assets. The result was a free lunch of higher returns and lower risk.
Fundamentally this behaviour made sense. We’re speaking of US exceptionalism. Solid relative gross domestic product growth, exceptional corporate earnings growth, competitive interest rates and the diversifying properties of the dollar’s safe haven behaviour supported strong capital inflows relative to other major countries.
It is exceptionally difficult for us to see how the US’ outperformance of the last 10-15 years can persist for the next 10-15 years, or even the next three to five. We believe this dollar free lunch era is over.
However, it is exceptionally difficult for us to see how the US’ outperformance of the last 10-15 years can persist for the next 10-15 years, or even the next three to five. We believe this dollar free lunch era is over.
In fact, we believe the dollar is headed towards a multi-year bear market that will ultimately see it fall by more than 15% across a broad basket of currencies. In addition, we expect the dollar’s negative correlation with equity markets to diminish, reducing its reliability as a safe haven.
Some of the drivers of US exceptionalism are likely to be persistent, including flexible labour markets, deep/flexible capital markets and leadership in key, innovative sectors. However, three of the major forces that drove US exceptionalism over the past 15 years are set to reverse: high fiscal deficits, low interest rates and globalisation (offshoring).
Over the 10 years through 2027, the US is projected to accumulate fiscal deficits equivalent to over 72% of GDP with overall debt to GDP exceeding 100% (Figure 1). That is not sustainable. One way or another the US will have to cut spending, raise taxes, engage in financial repression or do nothing until high-risk premiums on US debt crowd out private investment and seriously damage long run growth. Nearly all roads lead to a prolonged period of lower relative US growth and a weaker dollar.
Figure 1. US projected to accumulate unsustainable fiscal deficits
Cumulative fiscal deficit, 10 years to 2027, % of GDP
Source: SSGA
Meanwhile, US households and corporations locked in a huge amount of financing at rock-bottom rates when policy yields were at 0% during the Covid-19 pandemic. They did not feel the full pain of the tightening in monetary policy over the past few years, whereas much of the rest of the world was forced to take their monetary medicine thanks to a greater dependence on variable rate financing. This tailwind of lower US net interest expense is not repeatable over the next 10 years.
Finally, globalisation is reversing due to the impact of tariffs and the Donald Trump administration’s general animosity towards political co-operation, including moves to reduce the exercise of both soft power and military protection as well as the overuse of sanctions. These policy stances make the US a distinctly less attractive trade, financial and political partner in the eyes of the rest of the world – while also encouraging greater co-operation among countries outside the US on trade, supply-side investments and deregulation. A global turn away from the US is likely to further raise the cost of capital and slow potential growth, thereby hastening and deepening the fall in the dollar.
Markets do not appear to have priced these risks. Both the dollar and US equities remain expensive, still priced as though the degree of US outperformance for the past 10-15 years will continue for the next 10-15 years. According to the Bureau of Economic Analysis, non-US investors hold nearly $62tn in US assets, about $33tn of which is in portfolio investments. A mere 10% reduction in unhedged US exposure, either through an increase in the average dollar hedge ratio or rotation out of US assets, would require $3.3tn in dollar sales. This is more than enough to support a prolonged dollar bear market, and the portfolio rotation could easily be much larger.
Figure 2. The real trade-weighted dollar is expensive
Source: US Federal Reserve as of May 31, 2025
That does not mean the dollar will continue to fall as rapidly as it has year-to-date. It may do so, but US interest rates remain relatively high, which keeps hedging costly. And based on current budget proposals it does not appear that the US is ready to get its fiscal house in order yet. That may keep US growth on the resilient side while the short-run growth impact of tariffs is probably more negative outside the US, slowing the dollar’s descent.
The timing and pace of the dollar bear market may be uncertain but now is the time for investors to get ahead of the forces favouring lower US returns and higher US risk. They should consider alternative global allocations and currency hedging policies.