The Hindu: Published on 2nd Jan 2026:
Why in News?
The U.S. dollar is in focus after recording its worst annual performance in eight years, falling over 9% in 2025. Although there are signs of short-term stabilisation, investors widely expect the dollar to weaken further in 2026 due to expected Federal Reserve rate cuts, narrowing global growth differentials, and changing monetary policy dynamics.
Background / Context:
The U.S. dollar plays a central role in global finance, trade, reserves, and capital flows.
Over the past few years, the dollar remained strong due to:
Aggressive Fed interest rate hikes
Stronger U.S. economic growth compared to other major economies
In 2025, this trend reversed as:
Inflation moderated
The Fed signaled a shift toward monetary easing
Other economies began showing signs of recovery
Key Reasons Behind Dollar Weakness:
a) Federal Reserve Rate Cuts
The Fed has already cut rates and is expected to cut further in 2026.
Lower interest rates reduce returns on dollar-denominated assets, discouraging foreign investment.
Shrinking interest rate differentials weaken dollar demand.
b) Overvaluation of the Dollar
According to Bank for International Settlements (BIS) data:
The dollar’s real effective exchange rate remains historically high, indicating overvaluation.
Market strategists believe fundamentals still point to further correction.
c) Fiscal Deficits and Political Uncertainty
Rising U.S. fiscal deficits and political uncertainty reduce confidence in long-term dollar strength.
Expectations of a new Fed Chair raise speculation of a more dovish policy stance.
Global Growth Convergence:
Investors expect global growth to pick up outside the U.S., reducing America’s growth advantage.
Key developments:
Germany’s fiscal stimulus
China’s policy support
Improving growth prospects in the euro zone
As other economies strengthen, capital flows are likely to diversify away from the U.S. dollar.
Impact on Markets and Investors:
a) Positive Effects of a Weaker Dollar
Boosts U.S. multinational earnings by increasing overseas revenue value.
Makes emerging and international markets more attractive due to favorable currency translation.
Encourages global risk-taking.
b) Potential Risks
Sharp U.S. growth slowdown could:
Hurt investor confidence
Trigger broader market volatility
Accelerate dollar depreciation beyond expectations
Fed Divergence and Monetary Policy Outlook:
The Fed is expected to cut rates further, while:
Other major central banks may pause or tighten
This policy divergence weakens the dollar.
A divided Fed and cautious guidance signal uncertainty in future policy direction.
What Lies Ahead (Outlook for 2026):
Most FX strategists expect:
Gradual dollar weakening, not a collapse
Continued volatility depending on U.S. growth data
Some investors believe:
The worst may be over
But the upside for the dollar remains limited
Significance for the Global Economy:
Dollar movements affect:
Global trade
Capital flows
Emerging market stability
A weaker dollar could:
Ease financial conditions globally
Reduce debt burdens for dollar-dependent economies
Conclusion:
While short-term stabilisation offers some relief, structural factors—Fed easing, global growth convergence, and dollar overvaluation—suggest limited upside for the U.S. dollar in 2026. The currency’s trajectory will remain closely tied to monetary policy decisions and the relative strength of the global economic recovery.
