Multi-asset
Confounding returns: The mysterious case of the US dollar
5 min read 29 Jul 25
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The weakness of the US dollar this year has been unexpected as tariffs were widely expected to lead to the dollar strengthening. Tristan Hanson, Multi Asset Fund Manager, explores the factors that determine currency movements, from capital flows to interest rate differentials. While bearishness about the US dollar has increased, he suggests investors should be appropriately sceptical of the stories used to explain exchange rate movements.
The recent performance of the US dollar has been surprising and contrary to consensus opinion. The imposition of tariffs by the US administration was supposed to lead to US dollar strength.
Recent exchange rate (FX) behaviour has, however, been the polar opposite. The dollar fell more than 10% in the first half of 2025 against an average basket of other currencies1 .
As Ian Smith observed in the Financial Times, “the currency’s slide has confounded widespread predictions at the start of the year that Trump’s trade war would do greater damage to economies outside the US”2.
It was argued that the dollar should strengthen because US-imposed tariffs were set to make the exports of other countries to the US more expensive.
If the dollar didn’t go up in value, US-produced tradable goods would become relatively cheaper in US dollar terms compared to those of other countries, and US demand for goods from the rest of the world would diminish.
In theory, the exchange rate would consequently adjust to reflect the change in relative prices and somewhat offset the effect of the tariff.
If we ever needed one, this experience is a telling reminder that currencies can behave in highly unpredictable ways; and capital flows matter far more than trade flows when it comes to determining currency values.
The first point should be apparent to anyone with a few years of experience in financial markets. Keep track of consensus opinion and strategist forecasts (and your own) and you will soon see that they provide little insight into the future movement of exchange rates (or other asset prices for that matter).
The second point is more subtle; however, a cursory summary statistic makes the point. According to the Bureau of Economic Analysis, the total annual value of US imports and exports in traded goods for 2024 was $5.4 trillion3, while the Bank for International Settlements estimates that the total value of FX transactions in the US dollar amounts to over $6 trillion per day4. Financial flows in FX markets dwarf flows relating to traded goods5.
When viewed like this, it is no surprise that a country’s trade balance has very little predictive power of its exchange rate direction. Good luck trying to forecast the US dollar’s performance with economic statistics of this nature (even if sometimes they will seem to matter).
“This experience is a telling reminder that currencies can behave in highly unpredictable ways; and capital flows matter far more than trade flows.”
Narratives and beliefs
So what drives financial flows? In a word, beliefs; both about the (relative) attractiveness of a nation’s assets and the currency itself.
If investors believe the US dollar will go up – or they believe other investors believe the US dollar will go up – they will want exposure to it. They may choose not to hedge their US assets (witness the behaviour of Asian life insurers in recent years).
There may be a narrative such as “US exceptionalism” that fuels these beliefs. Technological dominance, strong economic growth and high US interest rates have added weight to this view. And nothing confirms a narrative like a trending price.
At some point all trends end. And with a change in trend, so too a change in narrative. Perhaps investors start to believe that US policymakers want a weaker dollar. Policy unpredictability that was tolerated before suddenly becomes a reason to avoid the dollar.
Cherished beliefs are challenged (eg, other equity markets start to outperform; the emergence of China’s DeepSeek challenges perceptions of technological exceptionalism).
Previous rules of thumb that had been correlated with dollar strength such as interest rate differentials start to break down. And then suddenly, if everyone else expects a weaker dollar, maybe I should too?
Viewing market behaviour in this way is not new. Robert Shiller’s ‘Narrative Economics’ and ‘Animal Spirits’, written with George Akerlof, emphasise the relevance of narratives to market behaviour6.
And there is almost always at least a kernel of truth to the prevailing narrative, otherwise it would be quickly rejected. Price action that confirms a developing narrative only cements the relationship as it provides validation. Until it doesn’t.
Assessing value
The role of narratives becomes stronger for assets which have only loose valuation anchors. Who is to say what is the right equilibrium level of the Euro/US dollar exchange rate?
When it comes to assessing fair value for a three-month Treasury bill it is, by contrast, quite straightforward: what is the interest rate today and how do I think it will change in the next three months?
There is not much room for debate in terms of how to value the asset, even if there is some uncertainty as to whether the central bank will change interest rates.
With currencies, the concept of value is much harder and the price determination mechanism inherently chaotic. At extremes, real exchange rates have a tendency both to exert real economic effects and to show some reversion to less extreme levels, but the process can take many years and real exchange rate valuations or PPP (purchasing power parity) are rarely helpful over most investment time horizons.
“With currencies, the concept of value is much harder and the price determination mechanism inherently chaotic.”
Away from extremes, there is little signal. Other fundamental factors such as economic growth, productivity, current account balances and interest rate differentials seem to matter some, but not all, of the time. In the absence of a ‘North Star’ for valuation purposes, trend following becomes the predominant investment strategy and narratives ebb and flow with the tide.
Rate differentials
The conventional focus on spot exchange rates is, in any case, misguided and only a part of the story as far as investors are concerned. Interest rate differentials (“carry”), which compound over time, can be a far more important determinant of FX returns7.
It will surprise most readers to learn that over the past 20 years, the Brazilian real has been a far better investment than the US dollar in total return terms…despite the real falling by 50% against the dollar in spot terms. This is because interest rates have been so much higher in Brazil.
With hindsight, a Brazilian investor would have done better to hedge their exposure to US assets rather than leave them unhedged even though the real has declined in value so significantly8.
As in this example, when carry is meaningful, it can often dominate versus the chaotic movement of the spot exchange rate, especially over an extended time horizon. This is why carry-based strategies remain popular and often rewarding, but they are prone to unpleasant short-term dynamics when positions get crowded and risk aversion picks up.
Future direction
Where does this leave us today regarding a view on the prospective direction of the US dollar against a basket of other currencies? It is appropriate to be humble regarding the spot direction or the narrative that will form to rationalise future moves, for the reasons outlined above.
We can note that dollar bearishness is much more pronounced than six months ago, if perhaps not in an extreme way. Will investors be surprised by a bout of dollar strength in the near future? It is entirely possible that they will be.
However, the unpredictable nature of current US policymaking and erosion of institutional norms is a potential threat to the long-run performance of the US dollar when US assets make up such a large share of global portfolios.
Short position
In our portfolios today, we are modestly short the US dollar as part of a funding basket for higher carry currencies, but not aggressively so. If the moves in the US dollar rapidly become more pronounced (in either direction) and accompanied by overblown rhetoric and signs of a strongly behavioural influence, then a contrarian opportunity may arise.
Until then, we should be both humble in our own ability to predict spot rate movements and sceptical of the reasons given by others to explain them, especially when they appear to express an unjustified level of confidence.
1 Bloomberg, July 2025.
2 Financial Times, ‘US dollar suffers worst start to year since 1973’, (ft.com), 30 June 2025.
3 Bureau of Economic Analysis, February 2025.
4 Bank for International Settlements, ‘Triennial Central Bank Survey 2022’ (bis.org), October 2022.
5 It is correct to argue that prices can change in a discontinuous fashion without any trade (or flow) occurring, although such a readjustment would be a financial response rather than one related directly to physical trade.
6 Narrative Economics: How Stories Go Viral and Drive Major Economic Events by Robert J. Shiller (2020) and Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George A. Akerlof and Robert J. Shiller (2010).
7 Interest rate differentials refers to the difference in interest rates between two countries. The “carry trade” is generally when investors borrow money in a country with a lower interest rate and invest it in a country with a higher interest rate, benefiting from the difference.
8 Assuming a one-off policy choice on 30 June 2005.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast, nor a recommendation to purchase or sell any particular security.
