• The weakening of the US dollar can be attributed to several factors over the course of this year, including economic, market and geopolitical dynamics.
  
  
• Some may wonder about the benefits of hedging to address currency movements; however, currency hedging offers no panacea.
  
  
• Instead, investors can help reduce overall portfolio volatility by maintaining a balanced and diversified portfolio across and within asset classes. 
   

However, the downward trend was significantly accelerated by the tariff announcements, which have added to the wider economic uncertainty, causing further depreciation of the dollar. This is unusual given that, historically, heightened uncertainty has resulted in a stronger dollar as investors sought safe-haven assets.

US dollar strength in reverse

Currency has been an important driver of UK versus US equity returns since the 1970s because a weakening GBP boosts a UK investor’s return on unhedged US assets. US equity market and US dollar strength have benefitted UK investors over the past decade, but those trends may now shift. Figure 1 shows how the difference in returns between UK and US equities is influenced by currency exchange rate fluctuations as opposed to the inherent performance of the underlying equity markets. 

Annualised 10-year trailing returns of European minus US equities

Past performance is not a reliable indicator of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Notes: The chart shows the trailing 10-year annualised total return difference between European equities (represented by the MSCI Europe Index) and US equities (represented by the MSCI USA Index). The “currency effect” refers to the impact of exchange rates on the difference in US equity market performance compared with that of the European equity market. It is best illustrated for European investors by showing the difference between the MSCI USA Index in US dollars and the same index in EUR. Indices are not directly investable. 

Sources: Bloomberg and Vanguard calculations, in EUR, as at 29 April 2025.

Currency hedging offers no panacea

The fluctuation of the US dollar has several implications for investors, depending on their goals, risk appetite and location. Some may wonder about the benefits of hedging to address currency movements; however, hedging is meant to address short-term volatility and can be costly over the long run, weighing on investors’ returns. 

As such, we encourage investors with a long-term horizon and wealth accumulation or preservation goals to hold global equities unhedged and global bonds hedged. This is to capture as much of the diversification benefit (of both underlying assets and currency fluctuations) as possible while ensuring that volatility is consistent with the comparable local asset. 

Currency hedges are implemented using currency futures contracts that typically expire over a period of one-to-three months and offer no panacea for investors facing the dual headwinds of falling US equity prices and US dollar depreciation.

Market expectations for US dollar weakening over the contract period are likely to be reflected in futures pricing. Currency hedging can yield an offsetting return only if US dollar depreciation during the contract period is greater than market expectations.

If hedging were needed beyond the initial one-to-three-month period, futures contracts would need to be rolled over into new contracts that would reflect updated US dollar depreciation prospects. As such, the investment eventually would produce similar returns whether hedged or unhedged.

The US dollar is unlikely to continue defying gravity

After a strong decade, the US dollar is now more reasonably valued compared with five leading currencies, according to our analysis. While the US dollar was undervalued at the start of the last decade, in recent years the currency had strengthened as capital flowed into US equity markets.

US equity market outperformance attracted more capital flows, strengthening the US dollar and, in turn, continued to push US equity prices higher, contributing to US equities becoming significantly overvalued.

We no longer view the US dollar as a tailwind for UK-based investors holding exposure to US equities. Together with still stretched US equity valuations, this explains our muted return outlook for unhedged US equities in GBP of 4.4% to 6.4% over the next decade, as at 30 April 2025. 

After a strong decade, the US dollar is within our fair value range

Past performance is not a reliable indicator of future results.

Notes: The chart shows our fair-value estimate for the US dollar against an equity market capitalisation-weighted basket of the euro, the Japanese yen, the British pound, the Canadian dollar and the Australian dollar. The fair-value estimate is based on the part of exchange-rate movements that can be explained through differentials in relative economic strength, measured by productivity (GDP per capita at purchasing power parity) and long-term real interest rates.

Sources: Vanguard calculations in USD, as at 31 March 2025 with actual data as at 30 April 2025 based on data from Refinitiv and the International Monetary Fund.

In a global economy with relatively free capital flows, money tends to move to the most productive countries where it can earn the highest returns. This has historically supported US equity valuations, lowered US bond yields and bolstered the US dollar.

The benefits of global diversification

In light of the recent US dollar weakness, it’s crucial for investors to maintain a balanced and diversified portfolio. Naturally, when the US dollar depreciates, other currencies appreciate. Diversifying across asset classes (equities and bonds) and within asset classes (styles, sectors and countries) can help reduce overall portfolio volatility.

While currency fluctuations are a natural part of the global economic cycle, a well-diversified investment strategy can help mitigate the risks and capitalise on the opportunity for long-term growth.

With thanks to Ben Vavreck for his contribution to this article. 
 

IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model® regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include US and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, US money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

The primary value of the VCMM is in its application to analysing potential client portfolios. VCMM asset-class forecasts—comprising distributions of expected returns, volatilities, and correlations—are key to the evaluation of potential downside risks, various risk–return trade-offs, and the diversification benefits of various asset classes. Although central tendencies are generated in any return distribution, Vanguard stresses that focusing on the full range of potential outcomes for the assets considered, such as the data presented in this paper, is the most effective way to use VCMM output.

The VCMM seeks to represent the uncertainty in the forecast by generating a wide range of potential outcomes. It is important to recognise that the VCMM does not impose “normality” on the return distributions, but rather is influenced by the so-called fat tails and skewness in the empirical distribution of modelled asset-class returns. Within the range of outcomes, individual experiences can be quite different, underscoring the varied nature of potential future paths. Indeed, this is a key reason why we approach asset-return outlooks in a distributional framework.

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