The US dollar is down but not out

The US dollar has weakened sharply — the DXY fell about 2% in January and is roughly 10.7% lower year‑on‑year — driven by Fed easing expectations (policy rate 3.5–3.75% after three 25bp cuts in Sept–Dec 2025 and markets pricing further cuts in 2026), aggressive US tariffs and geopolitical tensions. Trump’s tariff surge in April 2025 (initially lifting average effective tariffs from ~2.5% to ~27%) and concerns over rising US debt (near 125% of GDP) have sparked asset sell‑offs, capital outflows and safe‑haven moves (Swiss franc +13% in 2025; gold up from ~$3,100 to >$4,900 since April 2025), while sterling has rallied ~12% vs the dollar (from ~$1.23 to $1.37), easing UK import inflation but hurting UK exporters exposed to the US market.

Analysis

Market structure: A weaker dollar (DXY ~96.8, -10.7% y/y) reallocates real income and pricing power away from dollar earners to non‑USD issuers: winners include FX‑rich exporters (EUR, CHF, GBP) and dollar‑priced commodity assets (gold, energy), while US importers, dollar‑pegged debtors and UK exporters to the US are losers. Tariff-driven fragmentation raises bilateral trade frictions, favouring nearshoring and regional supply chains (EM Asia ↔ EU blocs) and compressing margins for firms exposed to US import markets within 3–12 months.

Risks: Tail scenarios include a policy U‑turn (Warsh appointment → hawkish Fed → rapid dollar rebound) or tariff escalation triggering global recession and a USD safe‑haven snapback; both are low probability but >5% each over 12 months. Near‑term (days–weeks) expect volatility around CPI prints and Fed/Fed‑nomination headlines; medium term (3–9 months) Fed cuts priced in (1–2 cuts in 2026) should be supportive of lower UST yields, while long term (years) structural de‑dollarisation remains slow.

Trades: Expect cross‑asset flows into gold, CHF, EUR and duration; anticipate 3–6 month rallies in GLD and long 7–10y Treasuries as cuts materialise, but hedge inflation with TIPS. FX volatility is high—use options to express directional views rather than large spot risk; pick pair trades that isolate USD weakness vs EUR/CHF/GBP rather than net equity directional risk.

Contrarian: Consensus overstates terminal reserve‑status loss and may be overstating permanent dollar decline—a faster Fed pivot or risk shock could provoke a sharp mean‑reversion rally. Historical parallels (Plaza Accord-style coordinated moves) show policy reversals can be rapid; mispricings exist in underowned long‑duration Treasuries and convex gold optionality versus crowded EUR long positions.

Key Decisions for Investors

• Establish a 2.5% portfolio long in GLD (or IAU) with a 6–12 month horizon; add a 3‑month out‑of‑the‑money call spread (buy 1, sell 0.5) sized to cap downside to -10% and target +30% upside if geopolitical/tariff risk persists.
• Buy 3‑month EURUSD calls or go long EUR spot equal to 1.5% notional exposure (or FXE ETF); set profit target +5% (implied DXY down toward ~92–94) and hard stop -3% from entry; increase if CPI prints and Fed commentary confirm two cuts in 2026.
• Tactically overweight 7–10y USTs via TLT at 3% portfolio weight for a 3–6 month window ahead of expected Fed cuts; hedge long‑run inflation by allocating 0.75% to TIP ETF. Liquidate if 10y yield rises >40bp from entry.
• Establish a 1.5% position in a dollar‑bear ETF (UDN) or buy puts on UUP to express conviction in sustained dollar weakness; concurrently trim FTSE/UK export‑heavy cyclicals by ~20% over 30 days (redeploy into EUR/CHF exporters or EEM) to avoid margin erosion from USD strength reversals.