Key Takeaways
- The rally so far in 2026 marks a recovery from the US dollar’s sharp declines in 2025, as investors now expect interest rate rises from the Fed.
- Analysts argue that the “de-dollarization” trend may be overstated, with the reserve status of the US dollar likely to remain intact.
- US dollar dynamics against the euro, British pound, and Japanese yen could shift this year, experts say.
The US dollar has staged a strong recovery in the first half of 2026, but whether those gains continue is up for debate. Resilient US economic growth, a shift in expectations toward a Federal Reserve interest rate hike in 2026, and continued global demand for American assets have fueled the dollar’s rise.
The US Dollar Index, which measures the value of the greenback against the world’s six most traded currencies, has risen 3% since the start of the year and 5% since late January, reaching a 13-month high of 101.8 in late June. The rally marks a sharp reversal from the first half of 2025, when the dollar recorded its weakest first-half performance in more than 50 years.
US Interest Rate Expectations Are Driving the Dollar’s Rally
Most analysts agree that the Fed has been the main catalyst behind the dollar’s recent strength. “We think this is mostly a Fed story,” says Muhammad Hamza Saleem, currency research analyst at Morningstar. “At the June 17 meeting, Kevin Warsh’s first as Chair, the Fed held at 3.50%-3.75%, but the new dot plot came out clearly hawkish. Markets repriced toward a higher-for-longer rate, and that is what we think mainly carried the DXY Index to a 13-month high.”
The dot plot signals Fed member voting intentions. It’s a closely watched indicator of the future direction of interest rates. Investors look for signs of “hawkish” sentiment, which indicates that policymakers are shifting toward raising rates.
At the same time, market expectations for rate hikes outside the United States have been scaled back in response to lower energy prices, according to MUFG senior currency analyst Lee Hardman. “The divergence in policy expectations between the Fed and other major central banks has resulted in yield spreads moving in favor of a stronger US dollar,” he says.
Geopolitical developments, including the Iran ceasefire, had only a limited impact. According to Saleem, lower oil prices would normally weaken the dollar, but investors focused instead on the Fed’s policy stance and lingering geopolitical uncertainty. “Markets cared more about the Fed’s hawkish shift and the notion of the US-Iran deal being highly fragile and lacking solidity, so it rallied anyway,” he says.
Can the US Dollar Keep Climbing?
Robert Waldner, chief strategist and head of macro research at Invesco Fixed Income, expects the dollar to continue appreciating over the near to medium term. “With oil back to its pre-Iran conflict levels, and non-US economies weaker than the US, nondollar interest rate markets still have room to compress their pricing of rate hikes, which should push USD rates higher relative to foreign rates. This dynamic has historically been supportive for the dollar,” he says.
Peter Kinsella, head of investment services UK at Union Bancaire Privée, says that by the end of the year, the dollar’s gains should become more pronounced against G10 currencies with lower yields, as is already the case against both the euro, the yen, and, to a lesser extent, the Swiss franc.
But MFUG’s Hardman believes the dollar’s recent strength will not prove maintainable: “Firstly, we expect the Fed to leave rates on hold as US inflation slows driven by lower energy prices and the fading impact from last year’s tariff hikes. Secondly, we expect growth to pick up outside the US, particularly in Asia and Europe, as the energy price shock fades. The improving outlook for global growth is likely to undermine the US dollar heading into next year.”
Morningstar analysts share the cautious view. “Our currency valuation model suggests that DXY is about 15% overvalued,” says Muhammad Hamza Saleem. “We think a lot of the current strength is cyclical, rate differentials, and a bit of risk premium rather than a genuine move in fair value, so we would look for limited upside from here and a slow drift back toward fair value. Overall, we’d expect it to firm through the back half this year and gradually soften into 2027 as those supports come off,” he adds.
The Outlook for the Euro vs. the US Dollar
Among specific exchange rate pairs, analysts offer differing views. Invesco’s Waldner is underweight in the euro. “Energy prices have come down meaningfully, which should ease one of the key inflation pressures facing the eurozone and allow rate hike pricing to compress relative to the dollar market. That relative shift in the rates story is the main channel through which we expect the euro to weaken against the dollar,” he says.
However, MUFG’s Hardman expects EUR/USD to rise back toward the top of the current 1.14-1.18 range later this year, as the Fed will disappoint expectations for rate hikes while the ECB has already raised rates once this year and could hike a final time in September. “We also expect economic growth in Europe to pick up later this year as the energy price shock fades,” he says. “However, it will be more challenging for EUR/USD to keep moving higher above 1.20 in the first half of next year given European political risks are due to intensify.”
At the same time, Morningstar’s long-term valuation-driven framework has become modestly more positive on the euro against the US dollar. “Recent dollar strength has improved the euro’s valuation backdrop, with our measures suggesting the currency is modestly undervalued versus the dollar,” says Michael Diamantopoulos, currency research associate director at Morningstar.
The Outlook for the Yen vs. the US Dollar
The Japanese yen has just hit its 40-year low against the dollar, retracing all its gains against the greenback and the euro since the Ministry of Finance intervened and Japanese authorities spent a record 11.7 trillion yen ($73 billion) to support their currency between late April and late May.
UBP’s Kinsella has recently revised his forecast for the USD/JPY exchange rate upward, predicting it will rise to levels as high as JPY 164 by the end of the year.
Lee Hardman believes that USD/JPY is close to peaking between JPY 160 and JPY 165. “Japan will intervene again to prevent the yen from continuing to weaken much further,” he says. “We expect USD/JPY to move lower as the energy price shock fades, and the Fed leaves rates on hold. In contrast, we expect the Bank of Japan to hike rates again in either September or October and lift the policy rate up to 1.5% by early next year. We expect USD/JPY to drop back into the low 150 by the middle of next year.”
Hong Cheng, Morningstar’s head of fixed income and currency research, sees the Japanese yen as significantly undervalued against the US dollar. “However, the fundamental backdrop remains less supportive, reflecting gradual BoJ policy normalization, weak domestic demand, and persistent incentives for global investors to fund carry trades in yen. Attractive valuation leaves us constructive on the yen over the medium to long term, but we expect any appreciation through 2026-27 to be gradual and contingent on a more meaningful narrowing in rate differentials, a carry trade unwind, or a faster-than-expected normalization of Japanese monetary policy.”
The Outlook for the GBP vs. the US Dollar
Overall, the British pound has proved more resilient than expected, despite weaker domestic data and a volatile political environment.
“Looking forward, a less attractive relative yield story should weigh on the pound, with politics and energy posing additional downside tail risks, that’s why we are also underweighting the British pound,” says Robert Waldner, chief strategist at Invesco.
According to Morningstar’s Diamantopoulos, the pound looks modestly undervalued against the US dollar. “However, the UK’s fundamental backdrop remains mixed, reflecting weak productivity growth, post-Brexit trade frictions, and sensitivity to energy shocks. Taken together, valuation is supportive, but fundamentals are broadly neutral, which limits our conviction on the future direction of GBP/USD.”
US Dollar’s Reserve Status Looks Solid
“De-dollarization” has been discussed frequently since 2025 as investors wonder about changes in the structural demand for the US currency and its reserve status. Central banks have been gradually diversifying their portfolios away from the dollar, toward other currencies and gold, with Ukraine conflict and sanctions imposed on Russia having reinforced this trend. As a result, the dollar’s share of global reserves has fallen roughly 14% since 2002.
“We expect this trend to continue,” says MUFG’s Hardman. “If the US does not address its sharply deteriorating fiscal position, then it could lead to a bigger loss of confidence in the dollar in the future,” he adds.
However, Morningstar currency analysts say the dollar is unlikely to lose its reserve status. “We recognize that the trend is real, but in our view, we think it gets overblown. The dollar sits at roughly 56.8% of global reserves as of Q4 2025, down from its 72% peak in 2002, but that essentially puts it back where it stood in the mid-1990s, and it remains more than double the euro’s 20% share,” says Saleem.
Part of that decline is not countries selling dollars, but rather an effect of measurement, Saleem says. “Reserves are reported in dollars, so when other currencies move, the reported shares move with them. And tellingly, the dollar’s share has barely budged since the 2022 Russia sanctions, the very moment so often cited as the turning point for de-dollarization. We think the de-dollarization case is not unsupported, and we see that the concerns behind it are not baseless. But a reserve currency is not likely to be unseated by dissatisfaction. It has to be unseated by a credible alternative. And that is exactly what we think is missing.”
How Do Interest Rates Impact Currencies?
A country’s interest rates have a direct impact on exchange rates. As the US has higher rates than the eurozone, holding US dollar assets becomes more attractive to global investors, attracting inflows for those wanting higher yields. Exchange rates also reflect economic growth and inflation expectations. Again, the US economy is growing faster than the eurozone. The US dollar also benefits from being the world’s “reserve currency,” and global investors favor holding dollar assets like Treasuries and US stocks, which have outperformed this year.
