Why the dollar keeps coming back: a Fed study and what it means for markets

Fed researchers find the dollar’s swings are cyclical — and still central

The Federal Reserve’s new paper opens with a clear point: the US dollar’s role in global debt markets rises and falls with the economic cycle, but it never vanishes. That matters now because markets are asking whether recent shifts — a weaker dollar at times, a stronger dollar at others — signal a long-term change. The study says no. The dollar loses some ground in calmer times and gains it back when stress returns. For investors and policymakers, the key question is how to plan for those recurring moves rather than bet on a one-way decline.

How the Fed got there: what the paper measured and why its conclusion holds up

The Fed team looked at a wide set of data to track the dollar’s role. They used bond market records, foreign reserves, invoicing and trade patterns, and cross-border lending flows. That lets them see not just which currency is used for trade, but which currencies back loans and settle debt. They also studied episodes of market stress to see how demand for safe assets shifts.

The core finding is twofold. First, the dollar is subject to cyclical pressures. When global risk appetite is high and US rates are not especially attractive, other currencies and local markets can grab market share. Second, those gains are usually temporary because the dollar benefits from deep, liquid markets, wide use in invoicing and contracts, and the legal and institutional plumbing that supports large-scale cross-border lending. In plain terms: you can build an alternative, but the dollar’s plumbing is hard to replace.

The Fed backs this with examples showing how market depth and safety drive demand for dollars during turmoil. When investors need to move quickly and without frictions, they turn to dollar assets. The paper also shows that policy choices matter — shifts in US interest rates and global central bank moves can change the cycle’s timing and depth.

What this means for Treasuries, global bond spreads and FX volatility

Short-term: expect the dollar to behave like a safety valve. In periods of market stress or sharp risk-off moves, demand for Treasuries typically jumps and the dollar strengthens. That squeezes global bond spreads wider as investors flee riskier assets, and it raises funding costs for borrowers outside the United States who rely on dollar funding. For fixed income traders, that pattern is familiar: safe-haven flows push yields down on US paper while pressuring non-dollar markets.

Medium-term: cycles in dollar dominance affect the shape of curves around the world. When the dollar is dominant, global capital often chases US yields, which flattens foreign yield curves and tightens spreads for countries with deep access to dollar funding. When the dollar is less dominant, local markets see more demand and spreads can narrow. The Fed study suggests these shifts are real but reversible.

Long-term: the dollar’s structural advantages — depth, settlement systems, legal certainty — mean it is likely to remain the anchor currency. That does not prevent periods where other currencies or assets nibble away at market share, but those gains are fragile without matching the dollar’s liquidity and safety.

Practical market effect: expect FX volatility to spike around policy moves and geopolitical shocks, and for Treasury markets to remain the go-to refuge. Emerging markets and dollar borrowers should be treated as the main transmission channel for dollar cycles: when the dollar runs up, stress appears first in spread widening and credit strains outside the US.

Past cycles show the pattern — and the exceptions

History helps. After the breakdown of the Bretton Woods system in the 1970s, the dollar’s role shifted but remained central because of the US economy’s size and markets’ depth. After the 2008 financial crisis, the dollar surged as banks retrenched and safe assets were hoarded. During parts of the 2010s, especially when the eurozone stabilized and US policy looked less aggressive, the dollar’s grip loosened a bit. The pandemic was another clear example: initial panic pushed the dollar higher, then massive US policy support changed spreads and flows in complex ways.

Each episode shows a common rhythm: stress brings a stronger dollar and bigger US Treasury demand; calmer stretches allow limited diversification away from the dollar. There are exceptions — times when regional anchors play a larger role for local trade — but none of those exceptions broke the global pattern.

Can the euro, yuan or crypto realistically unseat the dollar?

Alternatives exist, but each faces big hurdles. The euro is large and liquid, yet it lacks the single-scale legal and political backing the dollar enjoys. China’s yuan (renminbi) has grown in trade use and central bank holdings, but capital controls and limited convertibility keep it from becoming a full substitute. Proposals for RWA-backed digital currencies, or the rise of stablecoins and tokenized assets, promise technical fixes but face regulatory, custody and liquidity barriers.

Geopolitics also matters. Sanctions and the dollar’s role in the global financial system both reinforce and threaten its dominance: they make alternatives appealing to some countries but also underline the deep frictions that would come from switching. Bottom line: credible alternatives are not impossible, but they are slow, costly and uncertain.

How investors and policymakers should act on the Fed’s findings

The Fed’s basic message is a risk-management one. Dollar cycles repeat, so prepare for both phases. For investors, that means thinking in three dimensions: duration, currency exposure and liquidity.

On duration: safe-haven rallies can push Treasury yields lower quickly. Portfolios that need stability should mind duration risk when volatility spikes, and consider liquidity buffers if they must fund in stressed markets.

On currency exposure: unhedged exposure to currencies that weaken when the dollar strengthens is a straightforward source of risk. Hedging matters more when dollar dominance is rising. For dollar borrowers outside the US, the cycle is a reminder that funding risks can jump fast.

On liquidity and stress indicators: watch dollar funding markets, cross-currency basis spreads and central bank reserves as early warning signs. Policymakers should note that changes in US policy settings can alter the cycle’s pace — and that global coordination matters when strains spread through dollar funding channels.

Overall, the Fed paper argues against assuming a dramatic, permanent shift away from the dollar. For investors and officials, the right stance is cautious and flexible: expect recurring episodes where the dollar behaves like the global safety valve and structure portfolios and policies to survive those swings.