What Will Fed Rate Cuts Mean for the U.S. Dollar?

The U.S. dollar has declined by about 4% since July against a basket of currencies including the euro, British pound and Canadian dollar and is now hovering near the low end of a broad trading range that has prevailed since late 2022. Over those past two years, every time the U.S. dollar index has dropped to this current level, it was due to expectations for lower American interest rates. Each time it fell, it rebounded.

Bloomberg Dollar Spot Index

Now, with the Federal Reserve embarking on what appears to be an extended rate-cutting cycle, the foreign exchange value of the U.S. dollar has the potential to continue falling. However, we don't expect a long-term dollar bear market to develop. The strength of the U.S. economy relative to its major trading partners—such as Mexico, Canada, China and Japan—tends to support the value of the dollar.

Relative yield changes have contributed to the dollar's decline

The factors pushing the dollar higher relative to other major currencies for much of the past decade remain largely intact. U.S. economic growth has continued to outpace growth in other major countries, and U.S. interest rates are higher than those in the rest of the Group of 10 (G-10) countries.1 Stronger growth and higher yields on government bonds tend to attract foreign investment and discourage outflows of capital.

However, those differences have narrowed over the past few months as the Fed kicked off its rate-cutting cycle with a larger-than-expected 50-basis-point (0.50%) cut. The yield on the Bloomberg U.S. Aggregate Bond Index has fallen compared to the Bloomberg Global Aggregate Bond Index excluding the U.S. (ex USD). It is now at its narrowest level in two years. In general, higher relative yields tend to make a currency more attractive to hold, as expected returns are higher.