Why the dollar may have much further to fall

“CONFIDENCE, ESPECIALLY international confidence, is a fragile flower,” warned William Treiber, a long-serving Federal Reserve official, to colleagues on the central bank’s rate-setting committee in 1961. “We must be constantly alert to conduct our monetary and fiscal affairs so that we provide no basis for those abroad to raise questions regarding the ultimate soundness of the dollar.”

The Federal Reserve and the Treasury Department are the stewards of the dollar at home and abroad. Kevin Warsh, President Donald Trump’s pick to lead the Fed, will become one of the currency’s most senior custodians if he is confirmed by the Senate to succeed Jerome Powell in May. Foreign-exchange markets have already reacted to the news of his possible appointment: despite his recent doveish talk, Mr Warsh’s earlier advocacy for higher interest rates helped arrest the slide of the dollar, which has declined in value by about 10% since the beginning of 2025 (see chart 1).

The strength of the dollar and America’s international credibility are not one and the same. But they are linked, and perhaps increasingly so, by the appeal of America as an investment destination. Mr Warsh will inherit a climate of nervousness overseas about dollar-denominated assets, whipped up by American belligerence towards its allies and Mr Trump’s upturning of decades of trade liberalisation. In the 15 years since Mr Warsh last served on the Fed’s board, the structure of foreign-owned investments in America has shifted dramatically. Investors have piled into risky assets, leaving the greenback more vulnerable to a spate of weakness driven by American underperformance and slapdash policymaking in Washington.

The declining weight of dollar-denominated assets in foreign-exchange reserves held by central banks around the world has often been cited as evidence that the currency’s global role is dwindling. That share has dropped from a high of 72% in 1999 to 57% today. Rich-world currencies including the Australian dollar, Canadian dollar and Japanese yen have picked up some of the slack. Central banks have hoarded gold, too, out of fear of geopolitical ructions and American sanctions.

But foreign-exchange reserves are a shrivelling proportion of the demand for dollars abroad. Seventeen years ago debt securities held by foreign governments and central banks accounted for about 38% of all portfolio investment into America and politicians fretted about the $1trn and more in Treasury bonds owned by Chinese institutions. Today reserve assets and other sovereign holdings of American debt securities amount to just 13% of the value of American portfolio holdings, the lowest level in modern history (see chart 2).

International buyers of American assets during Mr Powell’s tenure have been motivated by profits rather than protection. In less than two decades the share of foreign-owned American assets accounted for by American stocks has almost tripled, rising from a low of 21% in the aftermath of the global financial crisis of 2007-09 to a record 58% today.

The surge in risk appetite reflects positive developments. Many large governments in the developing world have adopted healthier macroeconomic policies and fostered domestic bond markets, allowing investors to swap some American securities for local debt. At the same time, American companies have proved to be innovative and vastly profitable, drawing legions of foreign investors to their shares.

But riskier assets are deemed so for a reason. Last year, as Mr Trump’s tariffs and fears of an artificial-intelligence bubble started to erode trust in American stocks, their total return fell below that of their global peers by five percentage points, the largest margin since 2009. The Magnificent 7—a bundle of gargantuan technology stocks that have led the American market for years—have largely flatlined for the past four months. Software stocks have tumbled and emerging-market equities are on a roll. Investors are beginning to take the prospect of a longer period of American underperformance more seriously than they have in years.

They are no longer seeking refuge where they used to. For decades investors have piled into Treasuries when markets are distressed, earning them the status of “safe haven”. But in April, after Mr Trump announced his wall of tariffs, long-term Treasury yields rose even as stocks sold off. The same happened again in both October and January, during tariff-related wobbles. It is hard for Treasuries to be safe havens when the American government itself is driving the turmoil. In the language of a horror movie, the call is coming from inside the house.

Only a small number of investors have properly rebalanced away from America. “Since the beginning of 2025, we have reduced our holdings in US government bonds in several tranches,” says Pablo Bernengo of Alecta, a Swedish pension fund with more than $150bn in assets. He explains that what motivated the decision was “reduced predictability” of America’s policy, its large budget deficits and growing national debt.

Others have doubled down on their bets. Diego López of Global SWF, a data provider, notes that sovereign investors still seek opportunities in America that they cannot find elsewhere. In 2025, the firm estimates, such investors piled $132bn into American assets, nearly double the total for 2024. Even excluding the single largest deal—the Saudi purchase of EA Games, a video-game company—overall sovereign investment into America hit its highest level in the six years during which the firm has published such data.

Such indicators mask a worrying trend, however. Although most investors still hang on to their American holdings, many are trying to cover their unhedged exposure to dollars. That process, which involves selling greenbacks, mechanically drives down the value of the currency. Hedging activity surged in April, when Mr Trump announced his shockingly high tariffs. Flows into American exchange-traded funds tell the same story: last year foreign investors piled into hedged funds but snubbed unhedged ones.

Hedging may accelerate this year. “My sense is that some of the faster money will have made bigger changes in 2025,” says an investor at a foreign pension fund with tens of billions of dollars invested in America. “Slower-moving money”, subject to firmer governance and with longer-term liabilities to worry about, will move gradually. But the hedging activity from these bigger pools of capital will continue. “There will be another wave, and another wave.”

Hedging may pave the way for more drastic action. As uncertainty persists, institutions are keen to insure against further turmoil by diversifying their portfolios. Many are eager to reduce their exposure to a small number of American technology stocks and to redeploy the capital towards Europe and Asia.

Investors’ greater focus on returns rather than safety is a risk for America in debt markets, too. The average yield on government bonds issued by G7 countries other than America has ticked up continually, making them more attractive. At 2.8%, it is now at the highest level since 2008. The gap between that yield and those of the average Treasury bonds has declined from 2.2 percentage points at the end of 2024 to just 1.2 percentage points today.

If large, patient investors turn their supertankers away from America, the greenback could come under irresistible pressure. The real danger for the dollar is American equities falling out of favour, says Aaron Costello of Cambridge Associates, an investment firm. “The geopolitics just adds fuel to the fire.” Soaring asset prices, flows into equity markets and a rising dollar have reinforced one another in recent years. Investors who wanted to stick to global equity benchmarks, denominated in dollars, bought ever more American assets as both stocks and the dollar rose. A weaker dollar will reduce the weight of American assets in global indices (see chart 3), forcing benchmark-hugging investors to sell them. That will further weaken the greenback, feeding a vicious cycle.

There is a recent precedent for such a phenomenon. Between 2002 and 2008, following the dotcom bust, American stocks underperformed the roaring bourses of Europe and many emerging markets. Over that period the dollar dropped in value by around 40%. And that slump probably understates what a repeat performance would look like, because it occurred during a period in which central banks everywhere were loading up on dollar-denominated reserves. They might not be hoarding so many Treasuries this time.

The growing view among investors is that Mr Warsh’s ascent at the Fed portends more uncertainty about the dollar. He is an instinctive hawk who has adopted a doveish approach of late to match the president’s credo. He is preoccupied with shrinking the Fed’s balance-sheet and is a far more political animal than many of his predecessors. His relationship with Mr Trump, and how much more the president gets his way on monetary policy as a result, will only become clear over time.

No rival asset looks ready to supplant the dollar as the world’s reserve currency. But demand for greenbacks can ebb meaningfully without any serious challenger emerging. The ongoing erosion of America’s safe-haven status, together with uncertainty over the policy and independence of its central bank, mean the dollar’s appeal increasingly rests on the ability of American assets to outperform those in the rest of the world. That is a precarious base on which to build investor loyalty.

“The dollar is the world’s reserve currency, bestowing key advantages upon us. But none of this is our birthright. It must be earned, and re-earned,” said one Fed official in 2010, as the European sovereign-debt crisis was unfolding. “We ought not to be dismissive of the threats to our privileged position in the world.” That official was a younger Mr Warsh. As he prepares to lead the world’s most important central bank, the dollar looks more vulnerable than at any time in recent history. ■