The U.S. dollar ended the first half of 2025 with its biggest loss since 1973. The dollar index, which measures the greenback against a basket of currencies of the U.S.’s major trading partners, fell about 11% from January through the end of June.
That decline also marked the end of a structural bull cycle for the dollar, which started in 2010 and ended in 2024 with an accumulated gain of about 40%.
Although the currency strengthened 3.2% in July, recovering some of this year’s depreciation, Morgan Stanley Research expects the decline to continue, possibly adding another 10% in losses by the end of next year.
“We're likely at the intermission rather than the finale,” says David Adams, head of G10 FX Strategy at Morgan Stanley. “The second act for the dollar’s weakening should come over the next 12 months, as U.S. interest rates and growth converge with those of the rest of the world.”
The U.S. currency depreciation could have significant impacts for consumers, businesses, investors and ultimately for the overall economy: It would be more expensive for Americans to travel abroad. U.S. assets could be less compelling for foreign investors. Import prices could rise, putting pressure on inflation. On the positive side, however, the weaker dollar could be a boost for American exporters.
A Changed View on U.S. Growth Outperformance
The consensus after the 2024 election of U.S. President Donald Trump was that another period of U.S. growth outperformance was about to begin, with strong economic expansion, continued capital inflows and outperformance of U.S. equities and the dollar.
That view changed in April after announcements about tariffs and the subsequent policy and economic uncertainties. Increasing worries about growth, inflation and public debt added negative pressure on the greenback. The U.S. dollar index lost almost 7% from the beginning of April to the end of June.
In its Midyear Economic Outlook, published in May, Morgan Stanley Research estimated that U.S. growth will slow to 1.5% this year and 1% in 2026, after growing 2.8% in 2024. while the Federal Reserve is likely to reduce interest rates from the current range of 5.25%-5.5% to as low as 2.5% by the end of 2026.
Because rate differentials are a fundamental driver of currency strength, the more that U.S. interest rates fall to match the levels of its peers, the more likely it is that the dollar will weaken. At the beginning of August, the key rate in the eurozone was 2%, 0.5% in Japan and 3% in China.
July Gains
The dollar rebounded in July in response to better-than-expected U.S. economic data, such as job creation. The numbers signaled that tariffs still haven’t had a significant impact on economic activity yet.
Morgan Stanley economists expect U.S. inflation to reach a peak in the third quarter, with the negative impact of tariffs on growth and employment likely to follow. This combination could prevent the Fed from reducing rates this year and then accelerate cuts in 2026.
“If we see more evidence over the summer that tariffs are increasing inflation, then it’s possible the dollar will receive more support,” says Morgan Stanley's Chief Global FX Strategist James Lord. “Yet, recent evidence of labor market weakness combined with policy uncertainty in the U.S., such as tariff negotiations and the recent debate about an early change in the Fed’s leadership, remains a source of downward pressure on the dollar.”
The Negative Risk from Hedging
Foreign investors’ behavior around their dollar holdings offers an important window as to how the dollar’s value might change in the coming months. Currently, foreigners own more than $30 trillion in U.S. assets, with European investors alone holding $8 trillion of U.S. bonds and stocks. According to Morgan Stanley Research’s estimates, just over half of the European holdings aren’t hedged, or protected against a decline by using instruments like forwards and options.
The fact that most foreign investors have chosen not to hedge their exposure, particularly on the equity side, reflects a view that the dollar will appreciate.
However, many foreign investors are starting to rethink this view and are adding FX hedges, which really means dollar selling, potentially decreasing its value further.
“The initial data suggest that hedging has picked up in the second quarter, but because of the size of U.S. asset holdings and given how much it was initially unhedged, we could be talking about a significant long-term flow,” Adams says. “We have a lot more to go from here.”
