Geopolitical instability weighed on the US dollar amid the Trump administration’s tariff policy and international disputes. This was compounded by a more dovish tone from the Federal Reserve, signalling a softer approach to interest rates in the coming year. The net result was a sharp decline in the USD versus the DXY index, a weighted average of six other major currencies. We highlighted elevated downside risk for the USD in Q1 2025 and suggested that market participants be prepared for the forecasted decline.
The fundamentals stayed firm while the USD slipped, opening a clear disconnect between the economic backdrop and the dollar’s moves last year. The most important variable when assessing interest rate dynamics is the real rate difference (RRD), which adjusts interest rates for inflation. As you can see in the chart below, historically these move directionally together, but this relationship strayed in 2025, with RRD declining as the EUR/USD rose, demonstrating the weaker dollar.
Looking forward, this creates a clear conflict between a steady economic outlook and increasing geopolitical uncertainty for the US dollar. Evidently, the latter was the dominant force in 2025, but we expect this to change in the year ahead. The higher interest rate environment in the US is likely to support the dollar, with the Fed easing cycle comparatively slower than other central banks, providing a favourable setting for investors.
But why will this support the dollar when it was unable to do so in 2025? With speculative selling and institutional hedging already elevated last year, much of the potential USD selling has already occurred. That leaves fewer marginal sellers in 2026, even if the international relations remain fractured. This increases the probability of an imbalance between potential buyers and sellers for the year and therefore an upside risk for the dollar.
Finally, the divergence between the interest rate environment and USD movements has typically resolved within 12 months (2017, 2020, 2022), which aligns with our forecast of a USD turnaround towards late Q1 / Q2..
In summary, the US endured an unusually unstable political period in 2025, and that uncertainty has weighed on the dollar. Much of the recent weakness reflects sentiment rather than fundamentals. As the noise fades, we expect the USD to move back in line with its underlying economic backdrop in 2026, and those fundamentals still look reasonably solid.
This commentary is for informational purposes only and does not constitute investment advice or a recommendation.
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Written by Andy Devine
