What Lies Ahead for the U.S. Dollar? ETFs That Investors May Consider

The U.S. dollar has enjoyed a strong run since tensions in the Middle East escalated, driven by robust safe-haven demand and expectations that higher oil prices could keep inflation elevated, reinforcing the case for a hawkish Fed.

According to TradingView, the U.S. Dollar Index (DXY) has gained 2.49% over the past month and 3.24% over the past six months. The outlook for the greenback remains constructive for 2026, with increasing expectations that the Fed will hike interest rates later in the year.

The value of the greenback is closely related to the Fed’s monetary policies. The greenback’s value tends to move inversely with interest rate adjustments by the Fed. Expectations of a more hawkish Fed stance also make the greenback stronger. Higher U.S. interest rates can strengthen the dollar by increasing its yield advantage and boosting demand for FX carry trades.

How Likely Is Another Fed Rate Hike?

According to the CME FedWatch tool, the probability of rates being increased to 3.75-4.0% at the September meeting has surged to 50%, compared with only 22.5% a month earlier, while the likelihood of the Fed keeping the rates unchanged has fallen to 33.1% from 76.1% in the same period.

Similarly, markets are anticipating a 46.7% likelihood of interest rates being increased to 3.75-4.0% in the October meeting, up from a 30.8% likelihood just a month earlier. There is a 23.5% likelihood of the rate being hiked to 4-4.25%, rising significantly from a 4.5% likelihood just a month earlier, per the CME FedWatch tool.

Do Structural Headwinds Lie Ahead for the Greenback?

Emerging structural headwinds cloud the long-term outlook for the greenback. According to a survey by the Official Monetary and Financial Institutions Forum (OMFIF), as quoted on a Reuters article, more central banks now expect to reduce rather than increase their U.S. dollar holdings over the next decade, citing rising political risks surrounding the currency.

Notably, this marks the first time the survey has found central banks favoring a reduction in dollar reserves over an increase. The survey suggests that reserve managers are gradually broadening their diversification strategies. Approximately 79% of central banks and 60% of public funds expect the global monetary system to become increasingly multipolar, prompting greater diversification beyond traditional reserve currencies.

Additionally, gold is also assuming a more prominent role in central bank reserve strategies. The survey found that a net 30% of respondents plan to increase their gold holdings over the next one to two years, a trend that could gradually reduce reliance on the U.S. dollar and create long-term structural headwinds for the greenback.

At the same time, June’s pullback in technology stocks highlighted growing concerns over AI valuations and the sustainability of the AI trade. As investors diversify toward economies with less concentration in technology, capital inflows into U.S. assets could moderate.

Decreasing investor appetite for U.S. assets could exert further pressure on the greenback. A redirection of funds away from the United States reduces demand for the greenback, weakening it as a result and reducing its value.

How Should Investors Approach the Greenback?

Despite growing discussions around de-dollarization, the near-term outlook for the U.S. dollar remains constructive. As markets increasingly expect the Fed to keep monetary policy restrictive, the U.S. dollar could remain supported over the coming quarters. This backdrop makes a bullish stance on the greenback compelling through year-end and potentially into next year, assuming the Fed maintains its hawkish bias.

That said, a gradual diversification of global reserves, with more central banks considering reducing their U.S. dollar holdings while increasing allocations to gold, does dampen the greenback’s long-term structural outlook. Although these trends are unlikely to threaten the dollar’s rally anytime soon, they could weigh on the currency over the longer run. As such, investors should gradually prepare for a more diversified global currency landscape over the coming decade.

While the shift is likely to be gradual, investors should closely monitor the Fed’s monetary policy, broader economic developments and evolving global reserve allocation trends when evaluating their long-term dollar exposure and diversification strategy.

ETFs Poised to Benefit From Dollar Strength

Below, we have highlighted ETFs that may benefit from a stronger U.S. dollar and are well-suited for investors with a bullish outlook on the greenback.

Investors can consider Invesco DB US Dollar Index Bullish ETF UUP and WisdomTree Bloomberg U.S. Dollar Bullish ETF USDU.

ETFs to Play Dollar Weakness

Investors with a bearish outlook on the U.S. dollar may consider the ETFs below.

Invesco DB US Dollar Index Bearish Fund UDN and WisdomTree Emerging Currency Strategy Fund CEW can be considered. While the near-term outlook remains favorable for the U.S. dollar, any transition to a bearish outlook for the greenback is likely to be gradual. Investors looking to capitalize on potential dollar weakness may therefore be better served by taking a long-term approach.

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Invesco DB US Dollar Index Bullish ETF (UUP): ETF Research Reports

WisdomTree Bloomberg U.S. Dollar Bullish ETF (USDU): ETF Research Reports

WisdomTree Emerging Currency Strategy ETF (CEW): ETF Research Reports

This article originally published on Zacks Investment Research (zacks.com).

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