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Negative sentiment around the US dollar has intensified in recent months, fuelling concerns about inflation and pressure on US government bonds. But such framing risks overstating the scale of the shift, argue Roger Hallam, Global Head of Rates, and Kelly Gemmell, Head of Fixed Income Product Specialism, Europe at Vanguard.
They suggest the dollar’s recent weakness represents a gradual adjustment from elevated levels rather than a structural crisis, even as longer-term forces, including shifting global capital flows, policy volatility and persistent deficits, continue to reshape its role.
In the analysis that follows, Hallam and Gemmell explain why this evolving backdrop is not just a macro story but an expanding opportunity set for investors. As currency dynamics shift and diversification becomes more important, relative value is emerging across non-US sovereign debt, term premiums and select credit sectors within global fixed income markets.
The US dollar has weakened in recent months and media coverage has raised the spectre of a “debasement trade,” fuelling fears of higher US inflation and pressure on US government bond markets.
We believe the US dollar is on a gradual weakening trend, but this is not a US dollar crisis. However, the counter-cyclical properties that the dollar has offered historically may be less assured in the future.
The dollar remains historically strong and structurally dominant despite recent weakness. The ICE U.S. Dollar index (which measures the value of the US dollar against a basket of other currencies) is heavily weighted to the euro, which can overstate dollar moves when the euro experiences sharp swings.
Broader trade weighted measures suggest a more balanced picture as shown in Fig 1. While the dollar is modestly lower over the past year, it remains higher over the last five years and broadly stronger than its long term average. In our view, the dollar is still slightly overvalued and adjusting from elevated levels, rather than entering a period of sustained decline.
We expect the US dollar to continue to drift lower over time, reflecting valuation and realignment of the global economic order rather than a structural breakdown reflecting any fundamental loss of confidence in the currency.
What’s behind the recent moves?
Europe’s push for greater political and economic independence from the US, combined with volatility in US policymaking, has increased the incentive for governments and investors to diversify away from US dollar exposure into other currencies. One of the dollar’s most apparent vulnerabilities is the size of the US current account deficit. Sustaining dollar strength requires sizable capital account inflows, and a recent softening in those inflows has contributed to the dollar’s downward drift.
Global ex-US investors have also typically owned US assets with low currency hedge ratios because the US dollar has tended to appreciate during times of stress, providing a degree of portfolio diversification. However, the decline in the US dollar alongside US assets in the aftermath of last April’s tariff announcements has led some investors to reassess this assumption, and there is evidence that investors are increasing their currency hedge ratios on US assets.
Emerging investment opportunities in fixed income
As investors seek greater diversification amid widening deficits, valuation impacts are beginning to emerge in fixed income markets. While a weaker dollar may provide near-term support for US economic growth, it also raises the risk of imported inflation. That dynamic could limit the US Federal Reserve’s (Fed’s) ability to ease policy and contribute to increased volatility in the US Treasury market.
Active fixed income managers who are nimble and focused on relative value are well positioned to capitalise on these conditions. Opportunities are especially compelling in non-US sovereign debt where currency appreciation may lead other major central banks around the world, such as the European Central Bank, Bank of Japan or Bank of England, to adopt more accommodative policy stances.
What it means for bond portfolios
While equity markets may get attention, we believe that global fixed income will become increasingly dynamic.
- Global bond opportunities offer diversification:
Our active fixed income team has been diversifying into non-US sovereign debt and credit to take advantage of changing global interest-rate dynamics. We try to capitalise on relative value between US Treasuries and developed market government bonds, such as German bunds.
- The return of the term premium:
With a weaker dollar and elevated debt levels across developed markets, rising term premiums create powerful opportunities for active long-term investors. A steeper yield curve allows investors to capture roll-down, elevated income levels via thoughtful positioning along the belly of the yield curve.
- Credit where credit is due:
Credit markets are unlikely to be left behind. A weaker US dollar may lead to easier financial conditions if US equity markets rise (~50% of US company earnings come from outside the US) and cause US economic growth to accelerate, making it more challenging for the Fed to ease quickly. Economically sensitive sectors like investment-grade corporate bonds and high-yield corporate bonds could benefit and historically provide extra income relative to government bonds.
While headlines about the US dollar may unsettle markets in the short term, we believe that a long-term view and an active approach to curve positioning, sector allocation and security selection remain powerful tools for driving investment returns.
Key Takeaways
- The US dollar has weakened, prompting concerns around inflation and pressure on US government bonds, but it remains strong by historical standards, reflecting an adjustment, not a crisis.
- Structural forces, including shifts in the global economic order, US policy volatility and the size of the US current account deficit, are gradually reshaping the dollar’s role
- In this environment, we are seeing relative value opportunities emerge in non US sovereign debt, term premiums and select credit sectors of the global fixed income market.
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Kelly Gemmell, CFA, Head of Fixed Income Specialism, PRD Europe, Vanguard
Kelly heads Vanguard’s Fixed Income Product Specialism team in Europe. Her team covers active and index mutual funds and ETFs.
Kelly joined Vanguard in 2022, having previously worked in discretionary portfolio management at Morgan Stanley and Credit Suisse. She analysed equity and fixed income securities and managed equity, fixed income and multi asset portfolios. She also led the development of the sustainable direct securities platform for both equity and fixed income securities.
Kelly holds a bachelor’s degree in business management from Kings College London, is a CFA charterholder and holds CFA Institute certificates in both ESG investing and Climate and Investing.
Roger Hallam, CFA Global Head of Rates, Vanguard
In his role as Global Head of Rates, Roger oversees the Global rates, Treasury, Mortgages and Volatility,Currency, and Money Market Teams at Vanguard. He is a member of Vanguard Senior Leadership Team and Senior Investor Team.
Prior to joining Vanguard, Roger had been at J.P. Morgan Asset Management for over 20 years, as a Senior Global Fixed Income Portfolio Manager, and more recently as Chief Investment Officer for Currencies. Roger obtained a B.S. in Virology from the University of Warwick and is a CFA charter holder.
