Should Investors Continue to Underweight the US Dollar Relative to Other Major Currencies?

Yes. We continue to expect the US dollar to weaken relative to other major currencies over the next several years. The dollar remains expensive by historical standards, and over multi-year horizons that starting valuation has usually mattered more than the shorter-term narratives that can keep currencies misaligned for a time. Recently, these narratives have included the Iran War and US artificial intelligence (AI) leadership, which have supported the dollar through firmer growth and rate expectations, in addition to continued inflows into US assets. We do not believe that these factors will provide indefinite support to the dollar, however. War-related support should fade while capital markets inflows look vulnerable due to substantial concentration risk, elevated valuations, and an evolving geopolitical landscape. Investors should therefore continue to underweight the dollar relative to other major currencies over a three- to five-year horizon.

The dollar had already begun to weaken last year and into early this year as its rich valuation, softer relative growth expectations, and growing unease with US fiscal and foreign policies weighed on sentiment. The Iran War then gave the dollar a lift by raising energy prices and increasing uncertainty, which prompted markets to reprice central bank policy paths. Until recent days, markets had been increasingly looking past the war in the Middle East. Although oil prices fell, the dollar retained its gains from that period and remains 3.7% above its pre-war level. Interest rate differentials have provided the clearest support for this dynamic. The Federal Reserve helped calm fears that it might drift toward an unduly dovish stance, and markets now price in a little more than two rate hikes by early next year. That shift has lifted the dollar back above the range it had traded in over the last year. We do not expect much more from this channel. While US core inflation is above target, wage growth continues to moderate, oil prices are well below recent highs, and the broad data do not point to a renewed inflation cycle. At the same time, a firmer macro and policy backdrop in Japan and Europe, aided by lower energy prices and fiscal spending, should make the external environment less supportive of the dollar over time.

Continued foreign demand for US assets has also helped keep the dollar stronger than valuation and external-balance fundamentals would suggest. Deep capital markets, superior corporate profitability, and AI leadership have continued to attract foreign savings into US assets. Such enthusiasm has offset the pressure that would normally come from large current account deficits, a deeply negative net international investment position, and heavy public borrowing that relies in part on foreign demand. These conditions do not constitute a near-term funding crisis, but they are a reminder that the dollar depends on continued capital inflows to sustain its elevated valuation. A large share of those inflows has gone into US equities, leaving the US dollar vulnerable if demand for those assets slows.

AI has helped extend that support, but we do not think it will do so indefinitely. Dollar-denominated revenues earned across the AI supply chain are often retained or recycled into dollar assets. Meanwhile, enthusiasm around AI has driven elevated US capex, bolstered US growth expectations, and kept global savings flowing toward US equities, reinforced by a pipeline of high-profile US technology IPOs. But this support rests on a narrow and potentially fragile market regime. If those IPOs disappoint, capex slows, enthusiasm around the theme fades, or foreign investors restart a rotation toward non-US equity markets, support for the dollar should weaken. That risk is already more visible, as market leadership has begun to broaden beyond the large US technology platforms that led earlier in the cycle, while more of the AI hardware upside is increasingly accruing to Asia. This is evident in the 18.9% year-to-date return of the MSCI AC Asia Index, in comparison to the 10.2% return of the United States. Broader geopolitical trends may reinforce this shift. Europe, parts of the Middle East, and much of Asia all have stronger reasons to retain capital at home to fund defense, energy security, and broader domestic infrastructure priorities.

The dollar still trades around 30% above its median real exchange rate and at its 95th percentile over the last 55 years. Such valuation levels historically have marked multi-year reversals, and we do not see a compelling reason why this cycle will be different. The main risk to this view is that the AI story proves even more supportive of US growth, corporate earnings, and capital inflows than we expect, keeping the dollar stronger for longer. The fragility of peace in the Middle East and any disruption to resumed traffic through the Strait of Hormuz also pose a near-term risk to our view. For now, markets are looking through that risk despite elevated tensions and renewed military operations, reflecting expectations that the path toward peace will continue.

But our central view remains that the forces supporting the dollar today are more likely to delay rather than invalidate a medium-term weakening trend. Investors should therefore continue to underweight the US dollar relative to other major currencies.