Standalone Fed easing will weigh on the US dollar

In the first half of 2025, the US dollar recorded its largest six-month decline since 1973. In recent weeks, the dollar has stabilised, but there are reasons to expect the currency to weaken further in the coming months and into 2026 as the Federal Reserve lowers interest rates. This will be the first time in years that the Fed is out of step with other major central banks’ monetary policies. We have downgraded our view on the US currency to negative. 

The dollar index, which measures the US currency against a basket of developed economies’ currencies, fell more than 12% in the first half of 2025, after a rally of almost 10% in the last quarter of 2024. Since the end of June the US currency has stabilised, with the dollar consolidating within a range of 1.14 to 1.18 against the euro, and between 0.79 and 0.82 against the Swiss franc. 

Nevertheless, further US dollar downside is likely in the quarters ahead. Persistent US policy uncertainty and the erosion of US market exceptionalism may continue to undermine demand for the dollar, as in the first half of this year. More than these factors, however, the start of the Federal Reserve’s interest rate cuts should prove a bigger factor weighing on the currency. Indeed, last week’s signal by Fed chair Jerome Powell that a cut may be warranted in September saw the dollar fall by another 1%. 

US dollar performance in a Fed easing cycle

Historically, the US dollar has tended to weaken as the Fed starts to ease monetary policy, but in the past, this effect has diminished as the central bank’s cycle progresses. Fed easing cycles after 1998 typically saw the US dollar soften into a first rate cut and then stabilise after a few quarters. In contrast, if we look at the dollar’s performance through easing cycles before 1998, the US dollar tended to weaken, but its depreciation lasted for a few quarters. 

The difference in the dollar’s behaviour is whether the Fed is easing policy in isolation, or in step with others

What is the main difference between these two periods? The actions of other major central banks at the point the Fed begins easing is key to the dollar’s behaviour. Put differently, the difference in the dollar’s behaviour is whether the Fed is easing policy in isolation, or in step with other central banks; standalone Fed easing weakens the dollar. 

Since 1998, central bank easing cycles have been far more coordinated with the Fed shifting policy, followed shortly after by other central banks. As others followed the Fed in reducing rates, interest rate differentials stabilised for the US dollar, diminishing any drag on the US currency created by interest rate cuts. In contrast, when we look at Fed easing before 1998, there were several periods when the Fed eased while other central banks, including Germany’s Bundesbank, the Bank of England (BoE) or Bank of Japan (BoJ), were not doing so. 

Dollar set to soften in 2026

We expect the Fed to begin cutting in September, and take its policy rate to 3.75% by the end of 2025, which is close to a ‘neutral’ level that neither stimulates nor slows the US economy. In contrast, both the European Central Bank (ECB) as well as the Swiss National Bank (SNB) may be at the end of their easing cycle with rates of 2.0% and zero respectively, while the BoJ is expected to continue cautiously raising rates from today’s 0.5%. Of the major central banks, only the BoE, currently at 4%, is expected to cut rates at the same time as the Fed. 

Accordingly, today’s most appropriate historical comparison is prior to 1998. That suggests the US dollar could weaken further as the Fed cuts and rate differentials narrow. 

Beyond other central bank actions, the shape of the US yield curve will matter. In the past, the US dollar has tended to weaken further when markets price lower short-dated yields, as today, with a rising ‘term premium,’ or additional compensation investors demand for the risk of owning longer maturity bonds. While we expect US long-term yields to moderate over time, we still expect the term premium to remain high, reflecting fears over the widening US fiscal deficit.

A further risk to the dollar could come from a perceived threat to the Fed’s independence

A further risk to the dollar could come from a perceived threat to the Fed’s independence. President Trump's attempt to fire Fed governor Lisa Cook is the latest attack by the US administration on the central bank. Any perceived loss of independence would show up in the form of further risk premium for the dollar.

Leaders and laggards

In recent months, the US dollar has diverged from its correlation with interest rate differentials and US policy uncertainty has made other currencies’ fundamentals more relevant. Currency performance has therefore been more closely related to economies’ relative creditor status. In other words, economies that have accumulated higher exposures to foreign assets – usually in the US - than foreigners have invested domestically, have experienced the strongest rallies in their currencies. 

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Many creditor currencies have stabilised after strong gains, and these rallies could resume. US policy and eventually lower currency hedging costs - as the Fed cuts interest rates - could lead to foreign investors either repatriating their US asset holdings, or at least hedging their currency exposures. This will add further pressure on the dollar. 

Net creditor countries could therefore see their currencies stay under pressure to appreciate further. In developed markets this includes the euro area, Japan, Norway, Sweden and to a lesser extent Australia and Canada. In emerging markets, it includes countries like Taiwan, South Korea, and Thailand, as well as Israel and South Africa. Our 12-month EURUSD assumption stands at 1.22. 

Net creditor countries could see their currencies stay under pressure to appreciate further

Switzerland’s exposure to foreign assets is largely due to the SNB’s currency reserves, rather than private sector holdings. This means that hedging demand from the private sector will have less effect on the currency. Also, because the Swiss franc often strengthens when investors are worried about the euro, a more positive outlook for the euro area’s economy in 2026 could limit the Swiss franc’s appreciation in the coming quarters. Accordingly, we see the USDCHF at 0.77 on a 12-month basis, but expect the risks for EURCHF to be on the upside of our 0.94 12-month assumption. 

The exception to this pattern is sterling, which should lag other currencies as the UK’s currency loses its yield advantage with falling BoE interest rates. The pound’s performance is also limited by high levels of government debt, and does not tend to benefit as much as other currencies from repatriation flows out of the US. As the interest rate advantage of sterling erodes, sterling should therefore underperform peers like the euro, although GBPUSD could remain within a range on a broadly weaker US dollar. We see EURGBP close to 0.90 and GBPUSD at 1.37 over 12-months. 

Relative yields developments will therefore be detrimental to the USD. Falling hedging costs, associated with lower US policy rates and less extreme short investor positioning, are also undermining investors’ need for dollars. Another 90- day Chinese tariff truce can also support emerging currency sentiment in the near term, and we have adopted a more positive view on emerging currencies.