The Dollar's Structural Resilience: Why Dominance Persists

The narrative of a collapsing dollar has paused. After a period of significant volatility, the greenback's dominance appears to be stabilizing, not breaking. The core thesis is clear: structural supports remain intact, even as the currency faces persistent headwinds.

The data shows a picture of controlled retreat. The U.S. dollar's share of global currency reserves edged lower to 56.92% in the third quarter of 2025, a modest decline from the prior quarter. More broadly, the dollar's weakness was pronounced through September, with the US Dollar Index (DXY) falling nearly 10% as investors grappled with policy uncertainty and fiscal concerns. Yet this decline appears to have found a floor. The IMF data indicates a stabilisation in the three months to the end of September after large swings earlier in the year, particularly driven by U.S. tariff announcements.

This stabilization is not a sign of renewed strength, but rather a settling into a new, lower plateau. The dollar's recent selloff reflected a mix of cyclical and policy-driven forces, including persistent structural pressures like rising US debt burdens and waning confidence in policy. The sharp depreciation has improved valuation relative to the start of the year, but the dollar still trades at a premium versus most peers. It is entering a more prolonged phase of cyclical weakness, not a secular decline.

At the same time, the gradual diversification of reserves continues, but at a measured pace. The share of reserves held in the Japanese yen increased to 5.82% in Q3, while the euro's share also rose. This marks a notable shift, with nontraditional reserve currencies' share exceeding 5% in several countries. The trend is real, but the pace is slow. The debate over de-dollarization is real, but the consensus is that any such shift would be very gradual. The dollar's role as the world's dominant reserve and settlement currency, and its safe-haven appeal, remain powerful structural anchors. For now, the stabilization suggests these anchors are holding.

The Drivers of Resilience: Fundamentals and Policy

The dollar's recent stabilization is not a return to form, but a floor being set by the underlying strength of the U.S. economy and the cautious path of monetary policy. The sharp selloff through September was indeed fueled by fiscal concerns and reduced confidence in policy, but it did not reflect a loss of fundamental economic power. Instead, a series of recent data points has provided a tangible anchor for the currency.

The most immediate support comes from a resilient domestic economy. In the third quarter, the U.S. economy grew at an 4.3% annualized rate, a robust figure that underscores the durability of the recovery. This expansion has been matched by a labor market that, while showing some softening, remains firm. The unemployment rate held at 4.4% in December 2025, up from earlier in the year but still within a range that signals broad stability. This economic strength directly influences the dollar's trajectory. When data like weekly jobless claims coming in well below expectations reinforces the view that the labor market is holding up, it reduces immediate pressure on the Federal Reserve to cut interest rates aggressively. That, in turn, supports the dollar's value.

This creates a clear tension for the Fed's policy path. The central bank is navigating conflicting signals. On one hand, inflation remains slightly above its 2% target, which could support holding rates steady or even raising them. On the other, a softer jobs market typically calls for stimulus. The result is a cautious stance. The Federal Open Market Committee is expected to move interest rates lower in 2026, but not substantially, with markets pricing in one or two interest rate cuts as the most likely outcome. This expected, measured easing is a key determinant for the dollar's future. It suggests a gradual normalization rather than a sudden collapse in U.S. yields, which would be a major drag on the currency.

Yet, the dollar's current position is one of overvaluation. Despite its recent decline, the currency remains overvalued relative to most global currencies. This is a critical point. It means the selloff has improved its valuation, but not necessarily corrected it. For a currency that has been the world's dominant reserve and settlement asset for decades, this persistent premium reflects deep structural advantages. The dollar's role as a safe haven during global stress, its unmatched liquidity, and the sheer scale of U.S. financial markets provide a powerful buffer against cyclical weakness. The stabilization we are seeing is the market recognizing that while policy uncertainty and fiscal concerns are real, they are not yet outweighing these fundamental supports. The path forward hinges on the Fed's ability to navigate its dual mandate without succumbing to political pressures, a challenge that will test the very independence that underpins the dollar's credibility.

The Structural Challenge: A Fragmenting Global Order

The dollar's resilience is being tested not by a sudden crisis, but by a slow, structural erosion of the very foundations that made it dominant. The core supports-economic size, stability, and openness to trade and capital flows-are being gradually worn down by U.S. policy choices. As noted in a recent Federal Reserve study, increased attention has been paid to the U.S. fiscal outlook, highlighted by a recent credit rating downgrade, and the U.S. has increased its level of tariffs, thereby reducing its openness to trade. These actions, while perhaps serving domestic political goals, subtly undermine the global confidence in the U.S. as a stable, rule-based economic partner. The dollar's role as a safe-haven asset is predicated on that stability; any perceived weakening of the underlying economic model creates a long-term vulnerability.

This vulnerability is manifesting in the composition of central bank reserves. The data shows a clear, if gradual, shift. The dollar's share of global reserves edged lower to 56.92% in the third quarter of 2025, a modest decline but part of a longer trend. More importantly, this decline is not being filled by the traditional "big four" currencies. Instead, as the IMF has observed, it is being met by a rise in what are termed nontraditional reserve currencies. These include the Australian dollar, Canadian dollar, Chinese renminbi, and others. This is a critical distinction: the dollar is not being replaced by a single rival currency, but is being diluted by a wider basket of alternatives.

This trend points to a broader, more profound shift-the fragmentation of the global economic order. As geopolitical tensions rise and economic blocs become more insular, countries are actively seeking to diversify away from the dollar. The appeal of these nontraditional currencies is multifaceted: they offer diversification, often relatively attractive yields, and have become easier to trade thanks to new financial technologies. The result is a world where the dollar's dominance is less about being the only option and more about being one option among many. This is a structural challenge because it changes the calculus for reserve managers. Even when the dollar is strong, as it has been recently, central banks are still choosing to hold less of it and more of a broader array of assets.

The bottom line is that the dollar's role is being redefined, not replaced. Its outsized share in global reserves remains immense, but the trend is clear. The combination of a less open U.S. economy and a world moving toward blocs is creating a more fragmented financial landscape. The dollar's dominance is being diluted, not by a rival, but by a wider pool of alternatives. This is the long-term challenge: a gradual, steady erosion of the dollar's unique advantages, one reserve portfolio at a time.

Catalysts and Scenarios: What to Watch

The stabilization we've observed is a moment of pause, not a resolution. The path ahead hinges on a few critical catalysts that will determine whether the dollar's dominance is merely pausing or entering a sustained decline. The key watchpoints are clear: the Federal Reserve's policy pivot, the pace of reserve diversification, and the resolution of U.S. fiscal and geopolitical tensions.

First, the Fed's interest rate path in 2026 is the single most immediate lever. The central bank is navigating conflicting signals, with inflation slightly above target and the labor market showing softening. This tension has led to a cautious forecast. As of late December, both the FOMC's own projections and fixed-income markets point to one or two interest rate cuts as the most likely outcome for the year. The current federal funds rate sits at 3.5% to 3.75%. The critical question is the magnitude and timing of any cuts. A shift from a hawkish stance to a more dovish one, especially if it accelerates beyond the current expectations, would likely accelerate dollar weakness by narrowing the yield advantage that supports the currency. Political pressures on the Fed's independence, highlighted by recent Supreme Court arguments and potential nominations, add a layer of uncertainty to this forecast.

Second, monitor the trend of reserve currency diversification as a leading indicator of structural change. The data shows a persistent, if gradual, shift. The dollar's share of global reserves edged lower to 56.92% in the third quarter of 2025, a modest decline but part of a longer trend. Crucially, this decline is not being filled by the traditional "big four" currencies. Instead, it is being met by a rise in nontraditional reserve currencies like the Australian and Canadian dollars, the Chinese renminbi, and others. This trend is striking because it continues even during periods of dollar strength, indicating a deliberate portfolio rebalancing by central banks. The appeal lies in diversification, relatively attractive yields, and improved tradability via new financial technologies. The pace of this shift will be a key barometer of global confidence in the U.S. economic model.

Finally, the resolution of U.S. fiscal policy and geopolitical tensions will be critical in restoring or further eroding that confidence. The dollar's role as a safe-haven asset is predicated on perceived stability and openness. Actions that increase fiscal uncertainty or reduce trade openness, as noted in recent Fed studies, subtly undermine this foundation. As the world economy becomes more fragmented, the dollar's dominance is being diluted by a wider basket of alternatives. The bottom line is that the dollar's future is not determined by a single event, but by the convergence of these factors. Watch for a dovish Fed pivot, a faster pace of reserve diversification, and the resolution of domestic policy and geopolitical risks. Their interaction will define the next phase of the dollar's story.