Exchange rates are fluctuating due to a variety of interconnected factors. Key among them are a country’s interest rates, inflation and economic growth, along with its trade balance, deficits and debt. These factors do not operate in isolation, but rather they interact in complex ways, and their relative importance can shift over time.
Until the end of 2024, two main forces drove the US dollar strength: US exceptionalism and the interest rate differential between the US and other countries. If we chart the spread between the Federal Funds Effective Rate and the European Central Bank’s target rate alongside the euro-dollar exchange rate, we see high correlation between the two, with both metrics moving in tandem over the past five years. The logic behind this is straightforward: higher interest rates offer banks and other lenders a better return than in other countries, attracting foreign capital. At the same time, those higher rates are also symptomatic of strong economic growth and controlled inflation.
However, this dynamic began to shift at the start of 2025. The interest rate differential and the euro-dollar exchange rate have since decoupled. Despite the US economy continuing to outpace the eurozone, and despite the ECB having cut interest rates by 200 bp compared to just 100 bp from the Fed, the dollar has lost 9% against the euro since the beginning of the year. Other factors have now come into play and are having a greater impact on exchange rate movements.
One such factor is President Trump’s erratic policies , which have had a definite negative impact on investor confidence. Instead of the dollar acting as a safe haven upon Trump’s first tariff announcement on Liberation Day, we saw sharp corrections in equity and fixed income markets, which failed to push the dollar up. Even when Trump walked back some of those policies and markets recovered their lost ground, the dollar merely held steady.
The market narrative has changed. The notion of US exceptionalism has been replaced by US uncertainty. Uncertainty surrounding the impact on growth, inflation and the debt level. Over the past decade, investments in US dollars have grown exponentially, leading to global portfolios with very significant positions in US dollars. A slight readjustment to portfolios can have a major impact as almost everyone was long the dollar. So, the dollar’s downside risk likely still has room to run.
Date of report: June 23rd 2025