Anatomy of a depreciation: the dollar in times of economic policy uncertainty
At least for now, and despite the depreciation it has accumulated so far this year, the value of the dollar does not appear to reflect any major change in the currency’s central role in the international monetary system.
The recent depreciation of the dollar, in a context of risk aversion in the financial markets, has triggered concerns among investors for two fundamental reasons. The first is based on an article published after last November’s presidential election by someone who is now one of Trump’s top economic advisers, defending the implementation of measures aimed at devaluing the dollar. The second was the announcement on 2 April of the mislabelled «reciprocal» tariffs, which introduced a higher-than-expected degree of trade protectionism, intensifying investor scrutiny over the new administration’s reform agenda. For these reasons, we must consider the possibility that the anomalous behaviour of the currency in April could be an indication that the market is assessing the risk linked to unorthodox economic policies in the United States, which could affect the dollar’s role as a reserve currency. Are there grounds for this viewpoint? For now, and despite the depreciation that the currency has accumulated so far this year, we cannot state with certainty that the current value of the dollar reflects any significant shift in its central role in the international monetary system.
Stephen Miran, the current chair of the White House Council of Economic Advisers, published a report in late November (prior to his appointment) exploring how the US could achieve various economic policy goals contained in Trump’s campaign programme.1 Miran proposed a variety of ways in which to: reduce the cost of debt servicing and increase US Treasury revenues, get US allies to play their part in defence spending, and improve the price-competitiveness of US industry in order to regain productive capacity and jobs, all simultaneously.
To achieve all these objectives, he proposed a range of measures which included, among others: higher tariffs, the devaluation of the dollar, and even a charge on the yields of Treasury bonds held by foreign governments. Throughout the report, Miran outlined ways to implement these measures either simultaneously or alternately, and through both multilateral channels (i.e. agreed with other countries) and, ultimately, unilaterally by the US.
The potential impact of these measures put investors on high alert. Therefore, the recent depreciation of the dollar2 in a context of risk aversion in the market, when the currency usually acts as a safe-haven asset and tends to appreciate in value, raised doubts as to whether the market was already pricing in the risk that the administration was implementing these less orthodox – and more profound – measures which Miran explored in his report.
However, several analyses indicate that these factors, although still on investors’ radar, have been transient, and the currency has returned to the levels indicated by its historical relationship with other assets and financial variables. One such relationship is the historical correlation between the dollar’s nominal effective exchange rate and the spread between real interest rates in the US3 and those of its main trading partners.4 In fact, the dollar’s nominal effective exchange rate is currently where this correlation predicts it should be5 (the observed level barely deviates from the predicted level) and it seems to have found some stability there (see first chart).
- 3. Measured as the difference between Overnight Indexed Swap (OIS) rates and inflation swap rates.
- 4. According to the weighting of the DXY index (the standard benchmark for the overnight nominal effective exchange rate),
these are: the euro, the yen, the pound sterling, the Canadian dollar
and the Swedish krona. - 5. Firstly, the joint movement of real rates in these currencies is obtained, excluding real rates in dollars (i.e. the first two factors of a principal component analysis), and this is then plotted against the DXY index.
The explanatory power of real rates for the exchange rate has fluctuated in recent months. Specifically, it decreased between last October and January this year. After the Fed began its cycle of rate cuts in September 2024, the narrative that prevailed in the market was that of a soft landing of the US economy, thanks to good employment data and prices that seemed to be converging towards the 2% target. Later, Trump’s victory breathed new air into that narrative of exceptional US economic growth.
In this context, the spread between rates widened, indicating a more appreciated dollar, and although the currency moved in that same direction, it did so more than the rates predicted. This decoupling was probably due to investors interpreting Trump’s set of policies – tariffs, immigration restrictions, tax cuts – as being particularly favourable for the dollar.
It was not until January – when investor sentiment regarding Trump’s policies changed and the depreciation trend that has pushed the dollar down to its current levels began – that the spread in real rates between the dollar and other major currencies recovered its great explanatory power for exchange rate fluctuations.
Thus, according to this analysis, the dollar’s see-saw movement over the past eight months appears to be more related to a shift in the narrative regarding Trump’s impact on the US’ economic growth potential over the coming quarters than it is to the proposals put forward by Stephen Miran. The fact that the appreciation of the dollar began in October, before Miran’s report was even published and in the opposite direction to that advocated by the report, is another piece of evidence to support the view that the dollar’s see-saw movement since then (the DXY index is less than 1% below where it stood on 30 September) has been mainly driven by other forces and narratives. In other words, what we have witnessed since September appears to be the rise and fall of a market narrative that was highly favourable for US assets (referred to by some as the «Trump trade»).
In a specific and simplified version of this analysis, focusing solely on what happened relative to the euro, the conclusion is similar: the dollar’s appreciation since October 2024 distanced it from the level predicted by the spread of real rates between the US and the euro area, but since then it has reverted to this predicted rate, albeit unusually quickly in the last two months following the announcement of higher public spending in Germany and Trump’s so-called «Liberation Day» on 2 April (see second chart).
In short, it seems clear that, although the market narrative has changed and investors’ sensitivity to any new «unorthodox» policy proposed by the Trump administration has soared following the announcement of the reciprocal tariffs, the fact is that if a structural shift in the dollar’s role in the international financial system in the short-term was considered to be a likely scenario, then the dollar should have registered an even greater depreciation than it has.
For now, the dollar’s structural strengths remain in place. Nevertheless, the mere suggestion of altering the value of the central asset of the international financial system has sent shivers throughout the market; its central role remains intact, at least as long as such suggestions do not materialise. As can be seen in the third chart, the dollar remains the international reserve currency, the most highly-traded currency in foreign exchange markets, the currency in which the majority of global payments are denominated and that in which the greatest volume of debt is issued. It will take more than reflections on possible reforms to change this.
- 1. A User’s Guide to Restructuring the Global Trading System (November 2024).
- 2. In its nominal effective exchange rate, it has accumulated a depreciation of more than 8% in the year and of more than 4% since the announcement of «reciprocal» tariffs on 2 April.
- 3. Measured as the difference between Overnight Indexed Swap (OIS) rates and inflation swap rates.
- 4. According to the weighting of the DXY index (the standard benchmark for the overnight nominal effective exchange rate),
these are: the euro, the yen, the pound sterling, the Canadian dollar
and the Swedish krona. - 5. Firstly, the joint movement of real rates in these currencies is obtained, excluding real rates in dollars (i.e. the first two factors of a principal component analysis), and this is then plotted against the DXY index.
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