Changpeng Wan
Just as markets began pricing in a dollar rebound, Morgan Stanley delivered a sobering counter-narrative: the greenback’s decline has much further to go. In a September 7 report, the investment bank argued that bullish dollar sentiments are premature and that structural headwinds—from evolving Federal Reserve strategy to shifting global investor behavior—will extend the dollar’s downtrend well into the future. Here’s an in-depth look at why Morgan Stanley believes the dollar bear market is only halfway through its course.
Why Markets Are Wrong About the Dollar Rally
Many investors have turned optimistic on the U.S. dollar, citing three primary factors: the resilience of the U.S. economy in absorbing tariff impacts, outperformance of U.S. equities relative to global peers, and economic fragility in Europe and Asia due to trade tensions and fiscal concerns. However, Morgan Stanley strategist James K Lord argues that these near-term factors ignore deeper, more persistent trends that will weigh on the dollar. The bank maintains that the dollar bear market is barely halfway through—a claim supported by macroeconomic indicators, monetary policy divergence, and structural shifts in global currency hedging.
Short-Term Optimism vs. Long-Term Reality
Market participants have been quick to extrapolate recent dollar strength into a longer-term trend. Yet Lord and his team caution that such optimism is misplaced. Temporary factors such as equity inflows and perceived U.S. economic exceptionalism are overshadowing fundamental vulnerabilities—including rising inflation expectations and a more accommodative Federal Reserve.
The Fed’s New Stance: Tolerating Higher Inflation
A central pillar of Morgan Stanley’s argument is the evolving monetary policy approach of the U.S. Federal Reserve. According to the bank’s U.S. economics team, the Fed is now more willing to tolerate higher inflation—a significant shift from its traditional hawkish bias. This change has profound implications for real yields and, by extension, the dollar’s valuation.
Real Yields Under Pressure
When nominal interest rates are suppressed by Fed easing while consumer prices rise—partly due to tariffs—real (inflation-adjusted) yields fall. Morgan Stanley highlights that this erosion of real returns represents a historic headwind for the dollar. Using a framework popularized by colleague David Adams, the team shows that periods of declining real yields have consistently corresponded with dollar weakness.
Market Pricing of Dovish Fed Policy
Morgan Stanley’s rates strategy team continues to take long positions in 5-year Treasuries, anticipating that the front end of the yield curve will price in a deeper and longer rate-cutting cycle. This expectation reinforces the bearish outlook for the dollar, as lower rates reduce the attractiveness of dollar-denominated assets.
The Myth of U.S. Economic Exceptionalism
Another widely held belief—that the U.S. economy will continue to outperform its global counterparts—is also being called into question. Morgan Stanley’s baseline forecast suggests that by Q4 2025, U.S. GDP growth will slow to around 1%, with only a marginal pickup in 2026. Such sluggish growth can hardly justify the “America first” narrative that has undergirded dollar strength in recent years.
Recent Data Hint at Slowdown
Softness in recent employment reports indicates that hiring momentum is stalling. Combined with weaker consumer spending and business investment data, these figures point to mounting downside risks. If growth moderates as expected, foreign investors may become less inclined to hold unhedged dollar exposures.
The Hedging Incentive
Lower U.S. interest rates are encouraging international investors to increase hedging of their dollar-based investments. This behavioral shift reduces net demand for dollars and amplifies selling pressure—a dynamic that Morgan Stanley believes is still in its early stages.
Policy Divergence: The Fed Isn’t Alone
Global central banks are moving in different directions, and these policy divergences are exacerbating the dollar’s weakness. While the Fed is lowering the bar for additional rate cuts, the European Central Bank (ECB) has adopted a more cautious stance, and the Bank of England (BoE) has recently sounded more hawkish. This policy mix reduces the dollar’s interest rate advantage and dims its appeal.
Eroding Trust in Institutional Independence
Beyond interest rate differentials, concerns are mounting about the durability of the dollar’s reserve currency status. Doubts about governance and central bank independence—long considered pillars of dollar strength—are growing. Even White House economic advisors have acknowledged that the dollar’s privilege comes with trade-offs, and Morgan Stanley warns that fiscal risks in the U.S. are often underestimated relative to those in Europe.
Implications for Investors and Traders
For those positioned long the dollar, Morgan Stanley’s analysis serves as a stark warning. The combination of falling real yields, slowing growth, and policy divergence suggests that the greenback’s downtrend will persist. Investors may consider reducing dollar exposure, increasing foreign currency holdings, or using hedging strategies to mitigate risk.
Currency Hedging Becomes Key
As hedging activity among international investors rises, volatility in forex markets may increase. Traders should watch hedging ratios and flow data for signals of future dollar direction.
The Road Ahead for the U.S. Dollar
Morgan Stanley concludes that the dollar remains vulnerable to growth disappointments and policy uncertainty. While episodic rallies may occur, the broader trend is likely to remain downward. The bank expects the dollar to weaken throughout the remainder of the year and advises clients to position accordingly.
In summary, the dollar bear market is far from over. Structural factors—including Fed policy, economic deceleration, and shifting investor behavior—suggest that the greenback’s decline has only reached the midway point. For market participants, this implies a need for caution, diversification, and active risk management. Stay informed on macroeconomic developments and central bank communications to navigate the currency markets ahead.
