Morgan Stanley: The "Dollar Bear Market" is only halfway through

As the market generally believes that the dollar has bottomed out and rebounded, Morgan Stanley released a research report stating that the dollar bear market is far from over, and the current decline is "only halfway through."

According to news from the Wind Trading Desk, a report released by Morgan Stanley on September 7 shows that the market's optimism about the dollar mainly stems from several aspects: first, the belief that the U.S. economy can absorb the impact of import tariffs better than expected; second, the U.S. stock market has once again outperformed its global peers; third, the negative impact of tariffs on economic growth in Europe and Asia, as well as concerns about the fiscal health of some economies, are unsettling investors.

However, Morgan Stanley strategist James K Lord pointed out in the report that these seemingly convincing arguments overlook the long-term outlook for the dollar. The firm firmly believes that the downward trend of the dollar has not ended; on the contrary, its decline is "barely halfway through."

The Federal Reserve's tolerance for higher inflation puts pressure on real yields, eroding the dollar's foundation

The core argument of the report directly addresses the Federal Reserve's policy shift. Morgan Stanley's U.S. economic team believes that the Federal Reserve is now "more willing to tolerate the threat of higher inflation."

This means that if market interest rates decline further under the guidance of the Federal Reserve, and inflation remains stubbornly above target due to the transmission of tariffs to consumer prices, then the real yields in the U.S. will be eroded.

The report emphasizes that, according to its colleague David Adams' famous four-quadrant framework, the erosion of real yields is "a historic headwind for the dollar."

In addition, the market's pricing risk for increased easing by the Federal Reserve is significant, and the firm's interest rate team continues to be long on 5-year U.S. Treasuries, expecting the front end of the curve to price in a deeper rate-cutting cycle.

The "American exceptionalism" narrative is difficult to sustain, signs of economic slowdown are emerging

Another major pillar supporting the dollar—the "American economic superiority" narrative—is also facing scrutiny. Morgan Stanley's baseline view is that by the fourth quarter of 2025, the U.S. GDP growth rate will slow to around 1% and will be slightly above this level in 2026. The report argues that such a growth rate is hard to support the argument that "the U.S. will outperform other regions of the world."

The latest weak employment report further shows that hiring has stalled, and the risks of growth downturn are prominent. A low-interest-rate environment will also encourage foreign investors holding dollar assets to increase currency hedging, a shift that will inevitably exacerbate the dollar's weakness.

Divergence in central bank policies and hedging demand: the "dual pressure" on the dollar

The policy divergence among major global central banks is becoming another straw that could break the dollar's back. The report analyzes that when the Federal Reserve "lowers the threshold for rate cuts," the European Central Bank (ECB) has "raised it," while the recent statements from the Bank of England (BoE) have also been "more hawkish." This combination clearly favors a weaker dollar.

On a deeper level, concerns about governance and institutional independence are emerging, and these factors that historically supported the dollar's reserve status are beginning to waver. Miran, the chair of the White House Council of Economic Advisers, also acknowledged that the dollar's privileged status comes at a cost to the U.S. Skeptics of the dollar often emphasize European fiscal risks but overlook that the U.S. is equally unable to remain unaffected In addition, lower U.S. interest rates will further encourage foreign investors holding dollar assets to engage in currency hedging. Morgan Stanley expects that this shift in investor behavior will become another factor driving the dollar weaker.

In summary, Morgan Stanley believes that the key risks facing the dollar are the growth outlook and uncertainties in monetary and public policy. The firm maintains its view that the dollar will weaken for the remainder of this year.

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