The Decline of the Dollar: Space and Path

The US dollar has just fallen out of a "new record," with a cumulative decline of 8.4% in the first five months of this year, marking the worst "start of the year performance" in history. As the dollar gradually moves towards decline, what will be its specific retreat space and path?

In a recent report on Tuesday, Huatai Research stated that after Trump announced reciprocal tariffs on April 2, the dollar's decline instead of an increase has become one of the market's biggest "counterintuitive" phenomena. Further analysis shows that the relative decline of the US economy, increased political polarization, rising debt risks, and intensified geopolitical conflicts are marginally weakening a series of long-term factors that support the dollar's position.

According to Huatai's calculations, the dollar is currently overvalued by 15-20%, while global investors are generally "overweight" in dollar assets. The trend of "rebalancing" dollar allocations will lead to capital flowing out of the US, potentially weakening the relative returns of US stocks, raising the yield center of US Treasury bonds, and triggering a weakening of the dollar.

Referring to the history of the British pound, the decline of the dollar may present a "gradual first, then abrupt change" pattern. If a Mar-a-Lago agreement or a debt crisis occurs that leads investors to question the safety of US Treasury bonds, or if clear alternative assets emerge, the dollar's position may decline more rapidly.

Factors Supporting the Dollar Are Being Systematically Weakened

Huatai Securities stated that Trump's significant tariff increases have led to a decline in the dollar, warning of the risk of the dollar's status "falling from grace":

Domestically, he disrupts congressional oversight through the DOGE organization, publicly intervenes in the independence of the Federal Reserve, and promotes the "Beautiful Big Plan," which keeps the fiscal deficit rate above 6% for the next decade. Externally, he imposes high tariffs on traditional allies and withdraws from multilateral institutions like the World Health Organization, undermining allies' trust.

Although these measures may bring short-term political gains, they fundamentally weaken global confidence in the US government's credit and dollar assets, accelerating the decline of the dollar's reserve currency status.

Furthermore, Huatai indicated that the main supporting factors for the dollar as a reserve currency have significantly weakened in recent years:

1. Relative Decline of the US Economy: The US GDP's share of the global economy has decreased from 28% in the 1980s to 24% in 2019. After the gradual decoupling of the renminbi from the dollar in 2015, the dollar's monetary zone share has significantly declined.
2. Increased Political Polarization: The ideological gap between the two major US parties continues to widen, and Trump's policies further weaken internal government checks and balances, increasing policy uncertainty.
3. Rising Debt Risks: The US fiscal deficit rate remains high, and debt is rapidly climbing. The three major rating agencies—S&P, Fitch, and Moody's—have successively downgraded the US sovereign credit rating, weakening the safe asset status of US Treasury bonds
4. Geopolitical conflicts intensify: Countries like Russia and Turkey continue to promote de-dollarization and reduce their dollar assets.

How much is the dollar "overvalued"? How much are dollar assets "overallocated"?

HTSC Research indicates that based on various measurement methods, the dollar is "overvalued" by 15-20%. If Trump eliminates the trade deficit through exchange rate adjustments, the dollar would need to depreciate by more than 15%:

• Purchasing Power Parity (PPP) method: The actual effective exchange rate of the dollar is overvalued by 16.8% relative to historical averages and by 7.7% relative to the past ten-year average. In the long term, the exchange rate is expected to revert to the mean, with an estimated cumulative depreciation of the dollar by 18% over five years, averaging 3-4% per year. However, the reversion process is lengthy, and if U.S. productivity improves relatively, the depreciation may be less than expected.

• Macroeconomic Balance method (MB Model): The current actual effective exchange rate of the dollar is overvalued by 10-15%. In 2023, the U.S. current account deficit as a percentage of GDP is -3%, which is 0.7 percentage points lower than the equilibrium level, indicating that the current actual effective exchange rate of the dollar is overvalued by approximately 11.6%.

If Trump plans to narrow the U.S. trade deficit through currency depreciation, the dollar may need to depreciate by more than 15% to bring the trade balance back to historical average levels. Research shows that a 10% depreciation of the dollar could improve the current account as a percentage of GDP by 1.4-1.5 percentage points, while the U.S. goods trade deficit is projected to be 4.1% of GDP in 2024.

The excess returns on dollar assets have led global investors to generally overallocate to the dollar, especially U.S. stocks:

• U.S. stock weight far exceeds economic size: In 2024, the U.S. accounts for 27.4% of global nominal GDP, but its share in the MSCI ACWI index is as high as 63.7%. The excess returns of U.S. stocks have led global investors to overallocate to them. From 2008 to 2024, overseas holdings of U.S. equity securities increased from $2.1 trillion to $18.4 trillion, with a compound annual growth rate of 14.5%;
• Foreign capital heavily holds U.S. Treasury bonds: In the fourth quarter of 2024, overseas investors accounted for 30% of the outstanding U.S. Treasury bonds, and many investors (such as life insurance companies in Taiwan, China) hold unhedged dollar assets.

Additionally, HTSC Research points out that from a country perspective, countries with a cumulative surplus against the U.S. may have the most overallocated dollar assets. Since 1990, the countries and regions with the largest cumulative surplus against the U.S. are China, the European Union, Japan, and ASEAN; relative to their own GDP, the countries and regions hoarding the most dollars may be Mexico, Taiwan, OPEC, ASEAN, and Japan. Over the past decade, Chinese exporters may have overallocated more than $1 trillion in dollar assets, and from 2021 to the present, unconverted income may be close to $500 billion

The Shockwave of "Rebalancing" Dollar Allocation: A Reversal of Capital Flows

In the medium to long term, the "rebalancing" of dollar allocation will have a profound impact on dollar assets:

• Narrowing Valuation Premium of U.S. Stocks: The valuation gap between U.S. stocks and non-U.S. markets may further converge, weakening the relative returns of U.S. stocks. Since 2025, the valuation premium of U.S. stocks over non-U.S. stocks has decreased from 171% to 144%.
• Rising Central of U.S. Treasury Yield: The reduction of U.S. Treasury holdings by overseas investors may push up the term premium. Research shows that when overseas official institutions sell $100 billion in U.S. Treasuries, it typically raises U.S. Treasury yields by 50 basis points on average.
• Declining Central of Dollar Index: As investors reduce their dollar exposure or increase hedging, the central of the dollar index is likely to decline.

As of 2024, the total assets held by overseas investors in the U.S. reached $62 trillion, with holdings in U.S. stocks, U.S. Treasuries, corporate bonds, and other assets exceeding $30 trillion; the total asset scale held by overseas official institutions is $6.6 trillion.

Learning from the British Pound: The Decline of the Dollar May Follow a "Gradual Then Sudden" Pattern

According to Huatai Research, referencing history, the world reserve currency has changed multiple times over the past 1450 years: Portugal → Spain → Netherlands → France → Britain → United States, with each reserve currency averaging 94 years, and the dollar has exceeded 100 years since 1920.

Based on the historical experience of the British pound, the decline of the dollar may occur in two stages:

Gradual Stage: Influenced by factors such as the dollar's first-mover advantage, the network effect of reserve currencies, and the lack of obvious alternatives, the initial decline of the dollar's status will be a slow process.

Sudden Stage: If triggering factors such as the implementation of the "Mar-a-Lago Agreement" or a U.S. Treasury crisis arise, leading investors to question the safety of U.S. Treasuries, the dollar's status may suddenly accelerate its decline.