Currency Conundrum

• No capital flight out of the US
• US Dollar weakness likely due to hedging activity
• Interest rate fundamentals re-emerge

Under pressure
​In recent months, the U.S. dollar has come under pressure, with many observers attributing its weakness to the perceived end of American exceptionalism and a supposed rotation of capital flows out of the U.S. This narrative has gained traction alongside the belief that the eurozone may be on more solid footing than previously thought. However, in truth, there have been no significant flows out of the U.S. Figures published by the US department of Treasury debunks the claim for rotation out of the US.
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The primary driver of the dollar’s decline has been hedging activity, not structural reallocations or changes in economic fundamentals. We believe that, over time, fundamentals will reassert themselves—and when they do, the dollar is likely to recover further.

Fig.1. Net foreign purchases of US assets

​Bond values move inversely to interest rates, so as rates soared in 2022, bonds nosedived in nominal terms.  In real (inflation-adjusted) terms, the impact was even more severe.

Hedging, Not Fundamentals
The dollar's decline, particularly in April and May, has been more a function of tactical positioning than a reflection of a meaningful macro shift. Corporates and asset managers increased FX hedging during the sudden dollar weakness experienced in April and May 2025 as the value of the US assets started to drop. Aggressive hedging turned into self-fulfilling cycle which pushed the dollar to depreciate further forcing more hedging. However, this has not translated into actual capital flight. The selling pressure on the dollar has largely stemmed from these hedging flows and a broad-based reduction in USD long positions. A research paper by Bank of International Settlements highlights this phenomenon.

The Currency Conundrum​
Rate differentials help underscore this disconnect. Despite the Federal Reserve holding rates steady with a "higher-for-longer" posture, the dollar weakened even against currencies tied to dovish central banks or slowing economies. This suggests a clear decoupling of currency moves from relative interest rate expectations—a sign that emotional and mechanical drivers, rather than fundamentals, have been steering FX markets.

Fig.2. Yield differentials point to a weaker Sterling and a stronger Dollar

The dollar’s sharp rebound in recent days is not a random blip - it’s a recalibration. When a market move is driven by sentiment rather than substance, it becomes inherently fragile. As soon as the pressure from hedging began to ease with trade deals being announced and positioning turned less one-sided, the dollar quickly snapped back toward more fundamentally consistent levels.

Such reversals are common when markets drift too far from macro anchors. The speed and scale of the move reflect how out-of-line the dollar had become, and how much room there still is for normalization.
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​​Fundamentals Still Support the Dollar
Looking forward, the case for further dollar strength remains compelling. The U.S. economy continues to outpace its peers in terms of growth, labour market resilience, and real yields. While the Fed is nearing the end of its tightening cycle, it remains cautious on cutting rates, especially compared to the ECB and other central banks that are already contending with softer data and disinflation.

This divergence in economic momentum and monetary policy should continue to favour the dollar, especially if risk appetite wanes or geopolitical tensions rise. With no material capital flight from the U.S., and with real-rate differentials still pointing in favour of the greenback, the foundation for a sustained rebound is solid.

Fig.3. Market-implied policy rates as at end July 2025

Summary
The recent dollar weakness has been more sentiment than fundamentals—more about hedging flows and narrative shift than true macro deterioration. Now that some of the froth has cleared, we expect fundamentals to take the lead again. In that world, the U.S. dollar still looks like the most credible safe haven and yield play. The currency conundrum, in our view, is resolving—and it's resolving in the dollar’s favour.
 
 
Hoshang Daroga, CFA
Investment Director, Elston Consulting