Morgan Stanley: Dollar Bear Market Only Halfway Through, Citing Fed Policy Shift

Morgan Stanley has released a report asserting that the dollar's bear market is far from over, despite widespread market optimism. The report, published on September 7, argues that the current downturn in the dollar is only halfway through its course. Market optimism surrounding the dollar is primarily driven by several factors, including the belief that the U.S. economy can better absorb the impact of import tariffs, the strong performance of the U.S. stock market relative to global peers, and concerns over economic growth and fiscal health in various regions.

However, Morgan Stanley's strategists contend that these arguments overlook the long-term prospects for the dollar. The firm maintains that the downward trend in the dollar is far from over and, in fact, is only halfway through its decline. The core of the report's argument centers on the Federal Reserve's policy shift. Morgan Stanley's U.S. economics team believes that the Federal Reserve is now more willing to tolerate higher inflation. This implies that if market interest rates continue to fall under the Fed's guidance, and inflation remains stubbornly above target due to tariffs being passed on to consumer prices, the U.S.'s real yields will be eroded. The report emphasizes that, according to the framework of David Adams, the erosion of real yields is a "historical headwind" for the dollar.

Additionally, the market's pricing of further easing by the Federal Reserve poses a significant risk. Morgan Stanley's rates team continues to take a bullish stance on 5-year U.S. Treasuries, anticipating that the front end of the yield curve will price in a deeper easing cycle. The report also questions the sustainability of the "U.S. exceptionalism" narrative. Morgan Stanley's baseline view is that U.S. GDP growth will slow to around 1% by the fourth quarter of 2025 and remain slightly above this level in 2026. Such growth rates make it difficult to support the argument that the U.S. will outperform other regions globally. Recent weak employment reports further indicate stagnation in hiring and highlight the risk of slowing growth. A low-rate environment will also encourage foreign investors holding dollar assets to increase their currency hedging, exacerbating the dollar's weakness.

The divergence in policies among major central banks is another factor weighing on the dollar. The report notes that while the Federal Reserve has lowered the threshold for rate cuts, the European Central Bank has raised it, and the Bank of England has taken a more hawkish stance. This combination is clearly favorable for a weaker dollar. On a deeper level, concerns about governance and institutional independence are emerging, challenging factors that have historically supported the dollar's reserve status. The report acknowledges that the dollar's privileged status comes at a cost to the U.S. Skeptics of the dollar often highlight European fiscal risks but overlook similar issues in the U.S.

Lower U.S. interest rates will further incentivize foreign investors holding dollar assets to engage in currency hedging. Morgan Stanley anticipates that this shift in investor behavior will be another factor driving the dollar's weakness. In summary, Morgan Stanley identifies the key risks to the dollar as its growth outlook and the uncertainties surrounding monetary and public policy. The firm maintains its view that the dollar will continue to weaken for the remainder of the year.