Synopsis:

Morgan Stanley argues that the USD’s recent weakening is only at an “intermission,” not the final act, with fundamental drivers and market dynamics pointing to more depreciation ahead. They see the currency’s pro-cyclicality, hedging flows, and limited macro impact so far as supportive of further downside.

Key Points:

• Fundamental Drivers Still Intact:
  • US rates are converging toward global peers, eroding the USD’s yield advantage.
  • Rising FX hedging costs and adjustments continue to add a risk premium, further weighing on the currency.

• USD Still Elevated:
  • Despite the 2025 slide, the USD remains near the top of its historical range, leaving room for more catch-down.
  • Pro-cyclical flows from index rebalancing and FX hedging will likely amplify further weakness.

• Limited Economic Drag — For Now:
  • So far, a weaker dollar has had minimal impact on US CPI and GDP, but Morgan Stanley estimates each 1% drop adds ~5bps to headline inflation and growth.
  • This means policymakers could tolerate more FX-driven tailwinds before they become a concern.

• Equity Earnings Tailwind:
  • A weaker dollar is a net positive for US large-cap earnings, given their high share of foreign revenue.
  • FX hedging affects actual exposure but is often under-disclosed, so earnings calls and subjective management commentary will be crucial to watch.

Conclusion:

Morgan Stanley sees the USD’s soft trend as incomplete, with rate convergence, hedging flows, and positioning still pointing to more downside. For risk assets, the bank highlights that a weaker USD could remain an underappreciated tailwind, especially for large-cap US equities with international exposure.