Diversification away from dollar-denominated securities has accelerated over the past few weeks as increasing unpredictability out of Washington has global investors hedging against further dollar weakness.
Conditions are coalescing to support another leg down in the value of the greenback because of erratic trade and financial policy out of Washington and the normalization of the Japanese economy after nearly four decades of malaise.
After a 12-year upswing, the dollar’s fall below its most recent trading range and below its five-year moving average suggests the potential for continued weakness.
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The dollar has lost nearly 12% since the start of 2025, according to the trade-weighted dollar index. This can be best illustrated by looking at the two other major currency benchmarks, the euro and yen.
The euro
The euro has been appreciating against the dollar for the better part of the past year. The euro appreciated by 14% in the runup to the April tariff announcement and into July.
Then after months of range trading, the euro shot up again recently, appreciating by more than 3% in the last two weeks of January, which is an enormous move in such a brief period and reflects increasing policy unpredictability out of the U.S.
The yen
The yen started 2025 appreciating against the dollar in the runup to the April tariff announcements. It then spent the rest of the year losing ground to the dollar as its economy and financial assets adjusted to changes in monetary policy and fiscal spending.
Since Japanese Prime Minister Sanae Takaichi recently announced a snap election to be held on Feb. 8, signaling an end to fiscal austerity, volatility has gripped both the yen and long-term bond yields.
In the last two weeks of January, the yen appreciated by nearly 4% following a 13% depreciation after April 2025.
It appears that verbal intervention by the Bank of Japan and the Federal Reserve may have been partially responsible for putting a floor under the yen over the past week.
The combination of erratic trade and financial policies out of Washington, the normalization of monetary policy as well as potential expansionary fiscal policy in Tokyo could affect global capital flows and the trillion-dollar carry trade that is part of the daily churn in foreign exchange and rate markets.
The takeaway
Exchange rates are a nation’s first line of defense, weakening when economic or geopolitical shocks take hold of the economy and strengthening when things are progressing.
The reaction of exchange rates to the rhetoric at the recent World Economic Forum in Davos and the prospect of major changes in Japanese fiscal policy provide vivid examples.
A weaker dollar implies a higher cost of imported goods and higher interest rates (to compensate for the risk of further currency weakness) and a higher cost of capital for business.
Perhaps just as important, given rising American debt and deficits, the U.S. needs a strong dollar to attract investors to purchase long-term government securities.
A de-facto weak dollar policy would put that at risk, creating the conditions for rising long-term U.S. interest rates at a time when the American political authority is pushing for just the opposite.
