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[HFM]

Date: 24th April 2025.


The Dollar's Role in a Recession Is Real—but Not Solo!



Trading Leveraged products is Risky


Key Takeaways


* The US dollar appears overvalued based on historical metrics.
* Foreign investor exposure to US assets is at record levels.
* Slower US economic growth and rising policy risks may reduce demand for the dollar.
* The greenback’s reserve currency status remains secure, but depreciation pressures are building.
* Inflation, trade balance improvements, and financial stability are all tied to the dollar’s trajectory.
* Trade policy, more than the dollar itself, may determine the path forward for the US economy.


Forecasting currency movements—especially the US dollar—is notoriously difficult. Compared to predicting GDP growth, inflation, or interest rates, estimating exchange rate trends poses even greater challenges. Yet, despite this complexity, there’s growing evidence that the dollar's recent 5% drop on a trade-weighted basis could be just the beginning.


The Dollar’s Decline: A Signal or a Catalyst?


According to the Federal Reserve, the real effective value of the US dollar remains significantly elevated—nearly two standard deviations above its long-term average since 1973. Historically, similar levels were observed only in the mid-1980s and early 2000s. Both periods were followed by sharp dollar corrections, falling by 25% to 30%.


Could a deeper depreciation trigger broader financial consequences?


Massive Foreign Exposure to US Assets Raises Red Flags


Global investors have significantly increased their exposure to US assets. The International Monetary Fund (IMF) estimates that foreign investors now hold around $22 trillion in US-based assets—representing approximately one-third of their total portfolios. Half of this investment is in equities, many of which are unhedged against currency risk. Should these investors begin reducing their exposure to US markets, the dollar could experience intensified selling pressure.


Even a pause in foreign inflows may weigh heavily. The United States runs a current account deficit of roughly $1.1 trillion per year, which must be financed through capital inflows. In reality, most of this financing has traditionally come from foreign purchases of US portfolio assets. If foreign demand for these assets falters, prices may fall, the dollar could weaken, or both could occur simultaneously.





Slowing US Growth Could Dampen Dollar Strength


If the US economy were expected to continue outperforming other global economies, dollar strength might be more sustainable. However, this no longer appears likely. Economic growth projections have been downgraded across major economies, and the US has been hit hardest. For example, Goldman Sachs has revised its 2024-2025 US GDP forecast from 1% to just 0.5%.


With rising policy uncertainty, weaker corporate earnings, and doubts about the Federal Reserve’s independence, international investors may become more cautious about increasing their US holdings.


Dollar Depreciation Isn’t a Death Blow—But It’s Not Irrelevant


Despite these concerns, a weaker dollar does not necessarily imply the end of its global dominance. It’s important to separate dollar depreciation from a loss of its global reserve status. Historically, the greenback has faced major swings before without losing its dominance as the world’s primary reserve currency. Its role as a global medium of exchange and store of value remains deeply embedded in the international financial system.


Implications of a Weaker Dollar


* Consumer Prices May Rise
A falling dollar could amplify the inflationary effects of recent tariffs. Core inflation, measured by the Personal Consumption Expenditures (PCE) Price Index, may rise from 2.75% to 3.5%, with dollar weakness potentially adding another 0.25 percentage points. Ultimately, American consumers are likely to bear the brunt of higher import costs.
* Exports Become More Competitive
A weaker dollar reduces the price of US exports (in foreign currency terms) while making imports more expensive. Over time, this shift could help reduce the US trade deficit—aligning with longstanding policy goals.
* Financial Conditions Could Tighten
While a depreciating dollar can support easier financial conditions, the context matters. If the drop is driven by reduced demand for US assets, including Treasuries, the benefits could be offset by rising borrowing costs or declining market confidence.


The True Recession Risk Lies in Trade Policy, Not the Dollar Alone


While dollar movements matter, they’re unlikely to cause a recession on their own. The bigger threat is aggressive trade policy. Additional tariffs, especially if introduced after the current 90-day pause, or an escalation in the US-China trade conflict, could tip the balance. These decisions could undermine investor confidence and business activity—regardless of where the dollar stands.


The dollar is part of the recession puzzle—but not the whole picture. Its overvaluation, dependency on foreign investment, and declining support from global investors could compound economic vulnerabilities. Still, it's policy—especially on tariffs—that could ultimately determine whether the US slides into recession.


Always trade with strict risk management. Your capital is the single most important aspect of your trading business.


Please note that times displayed based on local time zone and are from time of writing this report.


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Andria Pichidi
HFMarkets


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