US dollar hits three-year low – what are the implications of a reversal?

Why is the US dollar in decline?

Unpredictable policymaking and tariff turbulence have given investors pause for thought. The dollar has been at the forefront of this vulnerability hitting a three-year low. The benchmark DXY index – which measures the dollar’s performance against a basket of its major trading partners – is down by around 9% year to date. Against sterling, the dollar is down around 7.1% over the same period. The dollar is on track for its worst performance in almost 30 years.

This is uncharacteristic for the greenback, which is usually considered a ‘safe haven’ currency in times of global instability. It is also difficult to square with prevailing interest rate differentials as US rates remain elevated relative to regions like Europe. These conditions would normally attract capital inflows and bolster the currency but this expected dynamic has not materialised in recent times. It appears that two key pillars that would typically be supportive for the dollar—its role as a safe haven and the appeal of higher yields—seem to have weakened.

The reasons for its weakness are multi-faceted: the recent falls come after an astonishing run of strength. The dollar has been steadily climbing since the Global Financial Crisis and had started to look richly valued on a range of measures. The primary driver of the recent downturn, however, has been mounting fears over US economic progress. There are worries over the inflationary effect of tariffs and its impact on economic growth. As a result, this raises the risk of a stagflationary scenario, where rising prices occur alongside a slowdown in economic activity. This environment would make US asset less attractive to investors, lowering demand for the currency.

Dollar direction

The outlook divides investors. Some believe the recent weakness simply delivers a much-needed recalibration for the dollar, and it will be steady from here. They point out a weaker dollar may be necessary to address some of the US’s economic challenges such as making exports more competitive. Others suggest this may be the start of more prolonged period of weakness for the US currency, including a threat to its position as the world’s reserve currency.

Either way, the shift has implications for investors, particularly non-US investors. For most of the past decade, the rising dollar has flattered the performance of US assets for international investors and has helped drive inflows into the US stock market. If this is no longer the case, it changes the considerations for international investors in the US. It is already the case that UK and European investors have not participated fully in the revival in US stock markets since early April. The dollar has dragged on their Euro or sterling-based returns.

Non-US investors have already started to recalibrate their long-held preference for US assets. Fund flows are starting to redirect towards Europe. If this trade builds momentum, it may wound the dollar further. The dollar is now an important risk factor for non-US investors.

Currency hedged share classes for some funds are available which can help to manage exchange rate volatility. However, the ongoing cost of maintaining the hedges means these share classes tend to be slightly higher than their unhedged counterparts. This can eat into performance returns over the long run. Investors should be aware that no hedging strategy has the ability to eliminate currency risk entirely and costs of hedging will vary from fund-to-fund.

What could a weakening US dollar mean for UK markets?

There are also implications for domestic UK and European markets. Many of the UK’s largest companies, for example the FTSE 100, are global in nature and some will have significant dollar revenues. The strength of the dollar has helped support those revenues, a phenomenon that may now reverse. There are also implications for dividends. The most recent Computershare UK Dividend Monitor calculated a £156m hit to UK dividends in the first quarter from Sterling strength, mostly against the dollar.

However, there are upsides for domestic companies. Outflows for the US, particularly from the technology sector, has buoyed UK stocks. The FTSE 100 in particular has been a beneficiary of this global diversification. It is up 7.6% since the start of the year, with its defensive sector composition attracting investors alongside strong performance from its signature banks, . The question is whether this strength will extend further down the market capitalisation scale. The UK’s smaller and medium-sized companies have been weak, particularly those with a domestic focus. These companies may be the least vulnerable to the ebb and flow of the dollar.

The bottom line

A strong dollar has been a major support for US assets over the long-term. Its weakness, whether it endures or not, will change the calculations for international investors. It may even halt their long-held preference for US assets over their domestic markets. There are signs that this is happening already and may accelerate if dollar weakness persists.