Dollar weakness will continue in 2026

2025 has been a turbulent year for currency markets, especially for the US dollar. It has been the weakest performing currency of the majors. The dollar index has fallen by 8%, with the declines ranging from only 1% versus the New Zealand dollar to more than 16% versus the Swedish krona. The euro has gained by around 12% versus the dollar. In this publication, we outline why we expect continued dollar weakness in 2026.

The dollar is overvalued in our view. To understand if the dollar is overvalued, we can use Purchasing Power Parity (PPP). PPP helps compare what money can buy in different countries, giving us a better idea of currency value. The graph below shows the results.

According to PPP, the dollar is most overvalued compared to the Japanese yen, with a PPP-based overvaluation of about 40%. Therefore, the dollar looks too expensive compared to the yen. This measure also implies a 17% overvaluation relative to the euro. When adjusted for the size of different economies, the PPP analysis suggests a EUR/USD valuation of 1.42.

Another estimate of the valuation of the dollar compared to the euro comes from our internal BEER (Behavioural Equilibrium Exchange Rate)-type model. This model uses quarterly data to estimate a ‘fundamental value’ of the exchange rate. This is based on key economic data, including trade flows, interest rates and relative price levels. The latest available data points to a ‘fundamental’ value of the EUR/USD at 1.23 – the highest since 2017 – and up substantially since its low in Q3 2024.

To understand the dollar’s current weakness, it’s worth revisiting periods when it was strong. The Federal Reserve’s trade-weighted dollar index, which compares the dollar to a basket of currencies based on trade flows, shows that the dollar is near historically high levels. It currently exceeds the previous peak of 2001 but hasn’t quite reached 1985 levels yet.

In 2001, the dollar had risen to its peak on the back of a series of global crises, from the Asian financial crisis to the bursting of the dot-com bubble, which made the US dollar a safe-haven currency for investors. The US economy was stable, interest rates were rising, and the government ran a budget surplus. After reaching its peak in July 2001, the dollar began to decline. Real interest rates fell, the surplus turned into a deficit, and the trade imbalance worsened.

In 1985, the dollar was even stronger, but the macro backdrop was different. The US economy was growing, inflation was under control, and real interest rates were high. Yet the country faced large fiscal and account deficits, meaning it was importing more than it was exporting and spending more than it was earning. That imbalance led to the Plaza Accord, a coordinated international effort to weaken the dollar.

Fast forward to today, some analysts have floated the idea of a modern version - the so-called ‘Mar-a-Lago Accord.’ While no formal agreement has emerged, the mere suggestion may have contributed to dollar weakness in 2025. The economy today resembles 1985 more than 2001. The US faces persistent and growing fiscal deficits alongside a record trade imbalance. Back then, the Plaza Accord helped weaken the dollar, but the macroeconomic backdrop played a substantial role as well. The question now is whether history will repeat itself.

We remain negative on the dollar looking forward due to cyclical and structural factors. To start with the cyclical factors, we expect the Fed to lower its policy rate further. A more dovish¹ Fed is not ideal for the inflation outlook (see more here). As a result, real interest rates will likely decline, and this is a negative for a currency.

Next to cyclical factors, we expect the structural factors, such as the fiscal deficit and the current account deficit, to gain more attention. The US fiscal deficit is on an unsustainable trajectory. Concerns about the fiscal deficit and government shutdown have contributed to dollar weakness via the increase in risk premia. This means that investors want higher compensation for the risk they take. Concerns about structural factors could continue to contribute to a weakening of the dollar. Besides a fiscal deficit, the US also runs a large current account deficit. Foreigners were willing to finance this deficit because of the special status of US assets and the US dollar. For now, foreign investors seem to hold on to their US assets, but they have started to hedge their exposure or have increased their hedges. If they were to decide to sell their US asset holdings, this could have a significant negative impact on US asset prices and the US dollar.

We expect dollar weakness to persist in 2026, driven by cyclical factors, such as more rate cuts by the Federal Reserve, and structural pressures from large fiscal and current account deficits. By the end of 2026, our forecast for EUR/USD is 1.25.

Georgette Boele
FX Strategist

Would you like to read more about our dollar outlook? In November, we published the article ‘Why the dollar is still overvalued.’ You can find our most recent currency forecasts here.

_{1 A dovish Federal Reserve refers to a monetary policy stance focused on supporting economic growth and employment. When the Fed is dovish, it typically favours lower interest rates to stimulate the economy. A hawkish Federal Reserve prioritises controlling inflation over growth. When the Fed is hawkish, it tends to raise interest rates or keep them high to curb inflation.}