The Dollar's Resilience Amid Rising Treasury Yields: A Tactical Rebalance for 2026?

The U.S. dollar's performance in 2025 has been a study in contrasts, oscillating between fragility and resilience amid shifting Treasury yield dynamics and divergent global monetary policies. As investors look ahead to 2026, the question of whether the dollar can maintain its dominance-or require a tactical rebalancing of portfolios-hinges on the interplay of three critical forces: the trajectory of U.S. Treasury yields, the Federal Reserve's policy path, and the diverging strategies of global central banks.

Treasury Yields: A Steepening Curve and Mixed Signals

U.S. Treasury yields in 2025 reflected a nuanced economic landscape. By December 31, 2025, the 10-year yield closed at 4.145%, up 3 basis points from earlier in the year, while the 2-year yield reached 3.469%. This steepening of the yield curve was driven by a combination of stronger-than-expected jobless claims data and a hawkish tone from Federal Reserve officials, who signaled caution about near-term rate cuts. Analysts from JPMorgan and BofA Securities projected the 10-year yield to hover near 4.1% into early 2026, with potential upward pressure to 4.35% and 4.25%, respectively, by year-end. These forecasts underscored lingering economic pressures, including the drag from tariffs and fiscal stimulus, which limited the downward momentum of long-term rates.

Meanwhile, the bond market demonstrated resilience in 2025, posting its best return since 2020. The Morningstar U.S. Core Bond TR YSD index yielded 7.3% for the year, fueled by 75 basis points of Fed rate cuts that boosted bond valuations. However, forward-looking indicators suggested a more cautious outlook for 2026. Traders priced in 60 basis points of Fed rate cuts, but analysts warned that re-accelerating economic growth could push long-end yields higher, potentially dampening bond returns. This duality-lower short-term yields versus higher long-term rates-creates a complex backdrop for dollar-linked assets.

Dollar Volatility: A Tale of Two Halves

The U.S. dollar's performance in 2025 was marked by sharp volatility. It depreciated by 10.7% against a basket of major currencies in the first half of the year, driven by rising inflation expectations, Fed rate cuts, and policy uncertainty. Tariff-related concerns further eroded confidence, as investors questioned the stability of U.S. institutions and fiscal sustainability. A pivotal moment came in May 2025, when Moody's downgraded U.S. sovereign debt, amplifying concerns about fiscal credibility.

By mid-year, however, the dollar stabilized and even rebounded slightly. This partial recovery was attributed to a shift in investor sentiment, as opportunities in Europe and other regions began to challenge the traditional appeal of U.S. assets. Despite these fluctuations, the dollar retained its role as the dominant reserve currency, though structural pressures suggested a long-term erosion of its influence.

Global Policy Divergence: A New Era of Uncertainty

The divergence in global monetary policy in 2025 added another layer of complexity. The Federal Reserve's cautious approach-cutting rates by 75 basis points in 2025-contrasted with the European Central Bank's (ECB) and Bank of England's (BoE) more neutral stances. The ECB maintained its key rate at 2% amid eurozone uncertainties, while the BoE held its rate at 4% but adjusted its quantitative tightening strategy. This divergence contributed to the dollar's 10.7% decline in 2025, as capital reallocated to markets with more accommodative policies.

The Bank of Japan (BoJ) emerged as a wildcard. By December 2025, the BoJ had raised its policy rate to 0.75%, a 30-year high, signaling a departure from ultra-loose monetary policy. This shift strengthened the yen, which traded near 156 to the dollar-a level not seen since 2012. The BoJ's normalization of policy disrupted global carry trades, which had long relied on borrowing in yen to fund higher-yielding assets. This ripple effect highlighted the interconnectedness of global markets and the potential for BoJ actions to indirectly influence U.S. Treasury yields and dollar strength.

Interplay of Forces: A Delicate Balance

The interplay between these forces-Treasury yields, dollar strength, and global policy divergence-created a volatile environment for investors. The Fed's rate cuts in 2025 lowered short-term yields but failed to anchor long-term rates, which remained elevated due to fiscal and growth concerns. Meanwhile, the ECB's and BoJ's policy paths introduced asymmetries in global capital flows. For instance, the ECB's potential rate cuts in 2026, if inflation undershoots expectations, could further weaken the dollar by making eurozone assets more attractive. Conversely, the BoJ's tightening cycle could indirectly support the dollar by reducing yen-based arbitrage and stabilizing global risk assets.

The U.S. Dollar Index (DXY) exemplified this tension. After a 11% decline in the first half of 2025-the largest in over 50 years-the index stabilized but remained vulnerable to further depreciation. Morgan Stanley Research projected an additional 10% loss by the end of 2026, citing a convergence of U.S. growth and interest rates with other major economies. This projection was tempered by the Fed's balance sheet adjustments, including resuming Treasury bill purchases and initiating reserve management purchases (RMPs), which aimed to stabilize short-term rates and banking system reserves.

Tactical Rebalance for 2026: Navigating the Unknown

For investors, the question of a tactical rebalance in 2026 hinges on three key considerations:1. Fed Policy Precision: The Fed's ability to navigate a fragile labor market and inflation risks will determine the trajectory of Treasury yields. If the Fed pauses or reverses cuts, long-term yields could rise further, potentially supporting the dollar.2. Global Policy Synchronization: A coordinated easing cycle among the Fed, ECB, and BoJ could stabilize the dollar, while divergent paths may exacerbate volatility.3. Fiscal and Geopolitical Risks: Persistent fiscal concerns and geopolitical tensions-such as the lingering effects of tariffs-could erode confidence in U.S. assets, prompting a shift toward alternatives like gold or eurozone bonds.

In this context, a tactical rebalance might involve hedging against dollar weakness by diversifying into eurozone or emerging market assets, while maintaining exposure to U.S. Treasuries for their liquidity and yield appeal. However, such a strategy requires close monitoring of policy signals and inflation data, as even minor shifts in central bank guidance could trigger sharp market repositioning.

Conclusion

The dollar's resilience in 2026 will ultimately depend on its ability to adapt to a rapidly evolving monetary landscape. While Treasury yields and global policy divergence introduce headwinds, the dollar's reserve currency status and the lack of viable alternatives provide a floor for its value. For investors, the path forward lies in balancing caution with opportunity-leveraging the dollar's strengths while mitigating risks through strategic diversification. As the Fed, ECB, and BoJ navigate their divergent paths, the markets will demand agility, not just endurance.