The US dollar as a safe asset – here to stay?

The US dollar has been the most widely used currency in trade, settlement, and financing since World War II. It also dominates central bank reserves. Recently, questions have emerged about whether the dollar can maintain its status as the leading international currency. Here we explore the dollar’s current status and why it is unlikely to be replaced soon.

Challenges to dollar dominance

The dollar’s greatest strength is its network effect: the more it is used, the easier it becomes to use. Any challenger must replicate its role across reserves, trade invoicing, and financing. It would also need to build decades’ worth of financial and legal infrastructure to offer a deep and liquid pool of safe assets to be used as a store of value and collateral.

In other words, just as the dollar became international slowly then suddenly, any successful challenge is unlikely to be a gradual transition but a more rapid development following a short interregnum. Running two systems in parallel is costly unless the world splits into rival economic blocs, as during the Cold War.

The only serious challenge to the dollar has come from the euro. It institutionalised Europe’s currency system centred around the Deutschmark and quickly gained reserve share, but mainly within Europe and its immediate trading partners. The lack of fiscal union means there is no single benchmark risk-free rate or safe asset with sufficient depth and liquidity. After the Eurozone debt crisis of 2012–14, talk of the euro as a reserve currency faded.

Other currencies, like the Korean won or Australian dollar, gained modest reserve share in the 2010s. But their strength relies on US dollar swap lines between the issuing central bank and the Federal Reserve. In crisis, their value lies in convertibility to dollars, not in serving as independent backstops.

More recent developments

Dollar centrality – and the need for access to US financial systems even for non-US transactions – enabled Washington to weaponise the dollar. The most striking example of this “weaponised interdependence” was the freezing of Russia’s central bank reserves after its 2022 invasion of Ukraine. This spurred central banks outside the Western bloc to buy gold as a hedge against sanctions, driving gold prices higher.

However, alternatives to the dollar have remained unrealistic. Returning to the gold standard in an era of free capital flows and globalised trade is practically unworkable due to the cost and effort needed to move, store, and provide enough of the precious metal. BRICS currencies lack deep, liquid markets, rule of law, and open capital accounts needed for reserve status. Rising gold holdings and non-US dollar reserves should be seen as diversification, not replacement.

The moves since Trump and where next

Diversification was already underway, but Donald Trump’s re-election accelerated concerns over the dollar’s long-term viability. His administration signalled a willingness to weaponise access to the dollar further and had no intention to tackle US fiscal deficits and debt overhang, which continue to have an impact on investor sentiment. This shift was evident during the “Liberation Day” market sell-off, when US Treasuries and the dollar fell alongside equities, while other safe-haven currencies rallied. 

While it did reflect a change in investor sentiment, it must also be viewed in terms of market positioning. The dollar started the year at cyclical highs, with stretched long positioning from asset managers and hedge funds heavily leveraged in Treasury futures basis trades. When volatility spiked, margin calls forced liquidation of liquid assets, including gold. Later, expectations of Federal Reserve rate cuts – driven by growth fears – pushed interest rate differentials against the dollar.

The dollar has since stabilised but faces headwinds from narrowing rate spreads. Still, its current level aligns with pre-pandemic norms and the 1990s, an era of tech-driven investment similar to today’s AI boom. In crises, we believe the dollar could still appreciate unless the shock comes from US policy itself.

What does this mean for asset allocation?

Our dynamic views on currency pairings solely manifest themselves in the form of risk management via the adjustment of currency hedging levels on underlying foreign asset exposure. Where we have foreign currency exposure within portfolios, we apply our dynamic views on top of our neutral view, as we do with any asset class. Within equity allocations, for example, we view 50% hedging of the main currency pairs as our neutral view. 

Currently, our overweight dollar view means that we hedge 25% of our dollar exposure and thus moves in the dollar vs sterling will have a greater impact on portfolios. It’s important to note that even our underlying view on the dollar vs sterling is largely impacted by portfolio construction and diversification considerations. In other words, we do not take directional views on the currency to generate alpha but rather use hedging level adjustments for risk management purposes.

The bottom line

The dollar’s story reflects a tension between its domestic and international roles: domestic needs often favour a weaker dollar, while global demand favours strength. These forces alternate in dominance. The current policy drive would imply a weakening of the dollar, but in times of global uncertainty, international capital can easily win out. 

Structural challenges persist – high deficits with no political will to tackle them, institutional erosion, increased weaponisation, and a drive to reshore manufacturing. Yet, with no viable alternative, it is unlikely the dollar will be knocked off its perch anytime soon.