A growing lack of investor confidence in U.S. policymaking and the general unpredictability of the American economy has emerged as a significant force shaping currency markets. So far, the consequences remain moderate, largely because the U.S. investment market still lacks any global alternative in terms of asset scale.
Since Donald Trump’s inauguration, the U.S. dollar has fallen by 10%. This decline is less about anticipated political shifts and more about investor distrust following unpredictable trade policy decisions and attacks on the Federal Reserve’s independence. Despite growing concerns, many investors remain tied to U.S. markets due to the lack of viable alternatives for reallocating the staggering $28 trillion net international investment position.
Even a fractional capital outflow could significantly disrupt exchange rates and global asset prices. Currency volatility is likely to remain elevated due to ongoing policy announcements, although fundamentals suggest that the EUR/USD exchange rate may stabilize around 1.12 by year-end, with risks tilted to the upside. Long-term valuation models show the dollar weakening primarily against Asian currencies, while European currencies appear fairly valued.
A Trump Promise Fulfilled: A Weaker Dollar
According to Allianz Trade, one of President Trump’s greatest accomplishments in his first 100 days of his second term has been delivering on his campaign promise to weaken the U.S. dollar. As of April 30, 2025, the trade-weighted USD index had dropped to its lowest level since 2022, marking a 10% decline since inauguration. At one point, EUR/USD exceeded 1.15, resulting in an 11% gain for the euro since the start of the year.
This depreciation was driven not by fundamentals, but by a loss of trust in U.S. leadership and economic policy, particularly after the “Liberation Day” tariff announcement three weeks ago and renewed threats to the Fed’s independence. Investors—both domestic and foreign—have since pulled back, further pressuring the dollar.
The Breakdown of Traditional Drivers
Typically, interest rate differentials drive currency movements. When U.S. rates rise, the dollar strengthens due to its yield appeal. But since Trump’s aggressive tariff announcements on April 2, this relationship has broken down. Investors are fleeing U.S. assets, despite higher yields, signaling deeper concerns.
Chart data (Chart 2) from Allianz Research shows that EUR/USD has decoupled from interest rate differentials. Japanese pension funds and European retail investors are scaling back their U.S. exposure.
The Problem of “TINA”: There Is No Alternative
Despite this, foreign investors face a structural dilemma: they are heavily invested in the U.S. and have nowhere else to go. The U.S. has long run massive trade deficits, offset by equally large capital inflows. As of Q4 2024, America’s Net International Investment Position (NIIP) stood at $26 trillion (Chart 3), equal to 85% of U.S. GDP or one-third of U.S. equity market capital.
If just a small share of this capital exited the U.S., it could trigger massive market disruptions. U.S. equities would fall, bond yields would rise, and the USD could plummet to 1.20–1.40 against the euro. However, such sharp moves would soon become unsustainable, and market forces would likely prevent further outflows.
Chart 4 illustrates how the U.S. dominates global capital markets, with 39% of global fixed income assets and 58% of equities domiciled in the U.S. According to Allianz Trade, no other market is capable of absorbing this investment scale.
Undermining the Fed: A Dangerous Move
The most recent dollar sell-off was accelerated by Trump’s verbal attacks on Fed Chair Jerome Powell, threatening the very independence of the world’s key reserve currency institution. While Trump initially blamed Powell for being “too slow and wrong” on interest rates and said his term “can’t end soon enough,” he later backtracked under market pressure, stating he had “no plans” to fire him.
Such overt political pressure on the Fed has not been seen since the 1970s, when similar interference contributed to runaway inflation. Studies suggest political meddling—rather than oil shocks or Bretton Woods’ collapse—was a major cause of 1970s inflation.
Today, inflation risks remain elevated, especially with Trump’s tariff hikes, which could push up prices. Though theoretically one-off, recent rises in medium-term inflation expectations (Chart 5) suggest these increases might de-anchor expectations from the Fed’s 2% target.
Therefore, rate cuts are not justified. Political pressure to cut only erodes investor trust in the dollar, reinforcing its current weakness. While Trump likely won’t remove Powell, he is expected to appoint a new chair after Powell’s term ends in May 2026, and may replace other board members. Such changes would slightly weaken the Fed’s perceived credibility.
Market Outlook: Volatility is the New Normal
We expect persistent volatility in FX markets, but maintain our year-end EUR/USD forecast at 1.12, as fundamentals ultimately prevail. Trump has shown he’s willing to walk back extreme policies (e.g., 90-day tariff suspension, not firing Powell) if markets panic. Such back-and-forth will likely continue, but macro fundamentals like interest rate differentials will dominate in the long term.
Allianz Trade forecasts EUR/USD to reach 1.12 by the end of 2025 and 1.10 in 2026, with wide confidence intervals (Chart 6).
Is the Dollar Overvalued?
Long-term valuation models show the USD is about 20% above its long-term real effective exchange rate (REER) average, making it overvalued. Meanwhile, the Japanese yen appears undervalued, and the euro, pound, and yuan are roughly fair.
However, REER relies on CPI indices, which can be arbitrary. Deviations from long-term averages are more meaningful than the levels themselves (Chart 7).
Big Mac Index: A Tasty Currency Test
An alternative view on valuation comes from price comparisons across countries, such as the Big Mac Index. A Big Mac costs $5.79 in the U.S., $5.95 in the eurozone, and $5.73 in the UK, but $7.99 in Switzerland, $3.52 in China, and $3.11 in Japan. This again suggests the dollar is overvalued against Asian currencies, but not dramatically so versus Europe (Chart 8).
Similar conclusions arise from Purchasing Power Parity (PPP) models, but these also have limitations. They assume identical consumption baskets across countries—rare, especially in emerging markets. As such, PPP is best used as a long-term directional guide, not a precise benchmark.
Source: https://ceo.com.pl/fundamenty-vs-chaos-polityczny-co-dzis-naprawde-wplywa-na-kurs-dolara-39384
