Bank of America: Limited downside potential for the dollar in the second half of the year!

According to the financial information app Zhitong Caijing, Bank of America Global Research published a report titled "Liquidity Insights: Mid-2025 Dollar Time Zone Review" on July 10, indicating that the dollar index is expected to fluctuate around 97 for the remainder of this year, close to the current spot price level. Although the dollar may fall below the bank's forecast, the continuation of current macro dynamics suggests that the downside potential for the dollar in the second half of 2025 is limited.

Core Views

The time zone framework indicates that the downside potential for the dollar in the second half of 2025 is limited. The Federal Reserve's decision not to cut interest rates in 2025 will provide moderate support for the dollar during U.S. trading hours.

After years of accumulated returns significantly retracing to flat, the dollar selling momentum during the Asian session has weakened.

The dollar still has room to weaken during the European session, but this requires stock markets in other regions to continue outperforming the U.S. stock market, and the bearish inclination of the hedging ratio has decreased.

Source: Bank of America Global Research, Bloomberg. [Defining U.S. trading hours as Coordinated Universal Time (UTC) from 2 PM to midnight, European trading hours as UTC from 8 AM to 1 PM, and Asian trading hours as UTC from midnight to 8 AM]

Dollar Time Zone Analysis

The dollar has experienced its worst annual start since 1973. For the second half of 2025, analyzing foreign exchange trends through the time zone framework indicates that the downside potential for the dollar may be even more limited. Although the overall trend of the dollar is no longer correlated with expectations of Federal Reserve interest rate cuts, the cumulative returns of the dollar during U.S. trading hours in 2025 still maintain a 71% correlation with Federal Reserve interest rate expectations. Keeping the Federal Reserve's interest rates unchanged for the remainder of this year will provide moderate support for the dollar during U.S. trading hours.

Although Asian investors have been the largest sellers of the dollar so far in 2025, looking at a longer review period, the dollar's performance during the Asian session has turned flat after the cumulative long returns over the past two years have retraced to neutral levels. Asian foreign exchange investors may wait for new bearish catalysts for the dollar to emerge in other time zones before further shorting the dollar.

The dollar still has significant depreciation space during the European trading session, but this may require global stock markets to outperform the U.S. stock market for the remainder of this year. Following the dollar's performance this year, the motivation for foreign investors to increase the foreign exchange hedging ratio of U.S. assets has weakened. In the first quarter of 2025, global stock markets outperformed the U.S. stock market, but in the second quarter, the U.S. stock market regained dominance. In the second half of 2025, global foreign exchange investors should focus on the relative performance of the stock markets.

Year-to-date Performance of the Dollar in Different Time Zones

In the first half of 2025, the dollar experienced its worst year-to-date performance since 1973 (see the report "Capital Flows," July 3, 2025). Although the dollar, represented by the dollar index, has seen a net decline in all time zones (see today's chart), the actual intraday performance is more complex. Notably, the dollar appreciated against the yen during U.S. trading hours, while it appreciated against the Canadian dollar during European trading hours (Table 1) The movements during the European and Asian sessions have driven the overall forex volatility of most currency pairs, with the Australian dollar against the US dollar and the US dollar against the Canadian dollar being exceptions. The returns during the US session continue to have a strong impact on them (Table 2).

Table 1: Despite the overall weakening of the US dollar in the first half of 2025, the US dollar against the Japanese yen rose during the US session, and the US dollar against the Canadian dollar rose during the European session — Performance of the US dollar against G10 currencies in different time zones in the first half of 2025

Table 2: The European and Asian sessions dominated the forex price movements of most currency pairs — Correlation of forex spot and cumulative returns in different time zones in 2025

The cumulative returns of the US dollar for one year and five years show different trends by time zone.

From a longer-term cumulative return perspective, the intraday cumulative returns of the US dollar also vary significantly. Table 3 shows that since the peak of spot prices in the fourth quarter of 2022, US investors have been cumulatively selling the US dollar; Asian investors have completely reversed the positive returns accumulated from 2023 to 2024, but the cumulative returns of the US dollar during the Asian session have not turned negative. For European investors, although they sold the US dollar in 2025, the net long dollar returns accumulated over the past few years are still more than 10% above neutral levels.

Table 3: From a long-term perspective, US investors are shorting the US dollar, while European investors are going long on the US dollar — Cumulative returns of the US dollar index by time zone since 2020

The dollar movements during the US session track the Fed's rate cut expectations.

Examining the cumulative returns of the US dollar in different time zones can provide additional insights. Although the spot price movements of the US dollar in 2025 are disconnected from the Fed's rate cut expectations, the dollar movements during the US trading session still have a -71% correlation with the market pricing of the Fed funds rate at the end of 2025 (Table 4).

Since April, as the interest rate market began to rule out the possibility of a Fed rate cut, US investors have reduced their short positions in the US dollar. If our US economists' baseline view of the Fed funds rate remaining unchanged in 2025 is realized, we believe the US dollar may appreciate moderately during the US trading session in the second half of this year Table 4: The dollar returns during the US session are driven by the Federal Reserve's interest rate cut expectations — Cumulative returns of the US dollar index during the US session and the market pricing of the Federal Funds rate

The further decline of the dollar during the European session requires the US stock market to underperform compared to other global markets.

Since 2020, the dollar's performance during the European trading session has shown a positive correlation with the performance of the US stock market relative to global stock markets. Represented by the ratio of the MSCI US Index to the global index excluding the US, Table 5 shows this correlation is +79%.

The weakening of the dollar during the European session in Q1 2025 coincides with the decline in this index ratio. However, in Q2, the ratio of US to global stock indices rebounded. Based on the recent performance of the US stock market, our equity strategists have raised the target for the S&P 500 Index (Note from Zhitong: In the report "S&P 500 Index Target Update" on July 8, Bank of America stated, "Undervaluing US companies is dangerous," and we acknowledge our oversight in ignoring our own advice on "Liberation Day." The resilience shown by large listed companies in the face of macro uncertainty prompted us to lower our equity risk premium (ERP) assumptions. Based on the persistent sovereign risks, we raised our standardized rate assumptions, but this only partially offset the positive impact of the lower ERP on valuations, ultimately leading to an increase in the year-end target for the S&P 500 Index from 5600 points to 6300 points, with the 12-month target raised to 6600 points.)

We believe that European investors still have a significant amount of dollar long cumulative returns to close, but for the dollar sell-off during the European session in the second half of 2025 to continue, forex investors may want to see this index ratio continue to decline.

Table 5: The dollar returns during the European session are driven by the performance of US and global stock markets — Dollar returns during the European session and the ratio of US to global stock indices excluding the US

Increasing the forex hedging ratio for US stocks is no longer a bearish factor for the dollar.

Earlier this year, we introduced a quantitative framework to estimate the forex hedging ratio of global investors for US stocks. Compared to the last update, the appropriate hedging ratio has decreased from 49% to 30%, indicating a reduced demand for foreign investors to increase dollar short hedging.

After a significant depreciation of the dollar in the first half of 2025, the current spot price of the dollar is now below the consensus forecast for the next quarter. Hedging costs remain high, and historically, the degree of dollar overvaluation has decreased (Table 7). Although the 12-month rolling correlation between the dollar and the US stock market remains positive, it seems to have peaked, and on a shorter-term 3-month rolling basis, the dollar has shown a negative correlation with the US stock market again Currently, none of these four factors support global investors in increasing their foreign exchange hedging ratio relative to the benchmark level.

Table 6: For Asian investors, the holding cost of shorting the dollar remains the highest — the annualized average holding return of buying the dollar against global currencies for 3 months

For Asian investors, the holding cost remains the biggest obstacle to shorting the dollar. The dollar's rise during the Asian trading sessions in 2023 and 2024 has largely been driven by the holding return demand from Asian investors. Among all geographical regions, the holding cost for Asian investors shorting the dollar is the most punitive in 2025 (Table 6).

The increase in volatility in 2025 has led to the unwinding of holding return trades from the past two years, pushing the dollar down against Asian currencies. To some extent, the dollar supply during this year's Asian sessions has also been driven by global investors increasing their foreign exchange hedging ratio for dollar-denominated assets, which in turn has exacerbated the holding cost penalty for shorting the dollar since the second quarter of 2025.

Notably, after investors in the region unwound all accumulated returns from dollar index long positions over the past two years, the cumulative return of the dollar during the Asian sessions has remained flat over the past month (Table 3). We believe that for the cumulative return of the dollar during the Asian sessions to turn into absolute negative values over a long-term five-year review period, the dollar may need to continue to decline in other time zones first, triggering a new wave of short dollar momentum that prompts price movements during the Asian sessions to follow suit.

Table 7: Due to consensus forecasts now lagging behind spot prices and the reduced degree of dollar overvaluation, the estimated foreign exchange hedging ratio for U.S. stocks decreased in the first half of 2025 — components of our estimate for the foreign exchange hedging ratio of U.S. stocks

Bottom line: Limited downside for the dollar for the remainder of this year, focus on stock market factors

Our existing currency forecast for the end of 2025 implies that the dollar index will fluctuate around 97 for the remainder of this year, close to the current spot price level. Although the dollar may fall below our forecast, the continuation of current macro dynamics suggests that the downside for the dollar in the second half of 2025 is limited.

If the market continues to rule out the possibility of the Federal Reserve cutting interest rates for the remainder of this year, price movements during the U.S. sessions will provide slight support for the dollar. Further supply of the dollar during the Asian sessions may require a new wave of dollar selling to occur first in other time zones.

The supply of the dollar during the European sessions depends on whether global stock markets can outperform the U.S. stock market for the remainder of this year, while the impetus to increase the foreign exchange hedging ratio for U.S. assets is weakening. We believe that in the second half of 2025, the relative performance of the stock market may be a key driver for global foreign exchange investors Table 8: The 1-year correlation between the US dollar and the stock market may have peaked, with the 3-month correlation falling to negative values — 3-month and 1-year rolling correlations between the US dollar and the US stock market