The past month has seen an abrupt turn in sentiment towards the US economy and the US dollar. Whereas a month ago, the market seemed convinced the US dollar would move higher from its already historically-elevated level of 108 on a DXY basis. Now debate surrounds whether the US dollar can even hold onto its current, lower level of 103.8.
What’s changed? We certainly have not seen an end to uncertainty around US trade policy. The initial month-long grace given to Canada and Mexico was followed by another partial reprieve to April 2, but the second deferral was paired with a promise that this would be the last.
Tariffs for steel and aluminium were subsequently brought forward from April 2 to March 12 with no exemptions. China was also hit with another 10% tariff increase and Europe warned it would soon face additional measures above those for steel and aluminium, which it has retaliated against.
With the US facing entrenched capacity constraints as well as tariffs, the outlook for US inflation remains troubling, keeping interest rate risks skewed to the upside, which is supportive of term interest rates and the US dollar. What has flipped the market’s view on the US dollar is instead the growth outlook, both in absolute and relative terms.
On an absolute basis, as detailed on page 17 of our March Market Outlook, incoming data for early-2025 is materially weaker than experienced through 2023 and 2024. GDP is forecast to decline in Q1 by the Atlanta Federal Reserve’s GDPNow nowcast but, as this outcome is the consequence of a one-off pull-forward of imports to get ahead of tariffs, the truer signal is the halving of domestic demand growth to a pace well below trend.
Business surveys also point to downside risks to the currently balanced state of the labour market. This is before we see any hit to job creation from DOGE’s initiatives and a pull-back by state and local governments, let alone if activity in the housing market and consumer demand continues to soften.
The reversal in growth expectations has been as acute for the Euro Area, but in the opposite direction. A potential loss of US military support for Ukraine has this month triggered an expectation that the Continent’s governments will materially increase defence spending. Mooted plans to also increase infrastructure expenditure in Germany was also well received. Other sectors of the economy remain under considerable pressure and at risk of shocks, but still Euro Area growth is likely to return to around trend in 2026 and remain there, in contrast to the below-trend outcomes of 2023 and 2024.
Broadly, we agree with the market’s take on recent data and expectations going forward. So, in light of participants’ change of heart, we expect further weakness in the US dollar through 2025 and 2026. Q2 is likely to be an exception however, with fear over the implementation of tariffs and consequent inflation, plus evidence the US is not entering recession, to see a partial reversal in favour of the US dollar.
From spot at 103.8, we therefore see the US dollar DXY index rising briefly to 105.7 at June, then back to the current level at September and 102.6 come December. A continued gradual decline in the DXY index is then expected through 2026, to 98.9 at December 2026 and 97.8 at June 2027. Underlying the dollar view are broad-based gains for Euro, Sterling and Yen as well as CAD – in time.
However, it is important to recognise that the forecast gains for each of these currencies sees them back near average levels – at best. If the US economy deteriorates to a greater extent than we anticipate, i.e. the economy stalls or recession ensues, there is plenty of downside risk for the US dollar and blue sky for the other side of each bilateral rate.
Arguably, these risks are likely to be most prominent in the coming three-to-six months as US tariffs are implemented, retaliated against and the consequences are progressively felt. This is also the time when the effect of changes to US immigration will also begin to be seen – a negative for growth and an additional source of inflation.
While not immediately relevant to the DXY outlook, the resilience of the Asian growth and investment story has the potential to create an environment conducive to a weaker US dollar.
Chinese authorities have made it clear they will support domestic growth as much as necessary and that they are also committed to aiding economic development across the Asian region. Much of the region is also aware of the risks US tariffs pose and intent on preserving their growth pulses. As they prove able to do so, they incentivise capital transfers from the ‘safe-harbour’ of the US dollar.
While we suspect it will take time, the countries of Asia therefore have the greatest capacity to outperform the DXY trend. China’s Renminbi, which we expect to fall from CNY7.24 to CNY6.80 at June 2027 against the dollar, and India’s Rupee, from INR 87.0 today to INR79.0, are best positioned, but countries like Indonesia and Thailand also have the capacity to leverage windfalls from manufacturing and services – tourism in particular. South Korea, Taiwan and Japan are more likely to get caught up in geopolitical and trade uncertainty, and have less flexibility domestically to offset.
This analysis first appeared in Westpac Economics’ March Market Outlook. The full detail of our FX, interest rate and economic forecasts for the world can be found on pages 23–30 of the publication.
