The U.S. dollar enters 2026 at a crossroads. After falling 9.4% in 2025—its worst annual performance in eight years—the world's reserve currency faces a year of anticipated volatility that could reshape portfolio strategies and international trade dynamics.

On the first trading day of 2026, the dollar index (DXY) held near 98.2, close to its lowest level since early October. The question investors are grappling with: Is the worst over, or is more weakness ahead?

Morgan Stanley's Volatile Forecast

Morgan Stanley's currency strategists have outlined a distinctive scenario for 2026. They forecast the U.S. dollar index, currently around 100, could fall to 94 in the second quarter of 2026—representing an additional 6% decline from current levels. However, they expect the dollar to rebound to 100 by year-end, completing a round trip that could whipsaw unprepared investors.

This "U-shaped" trajectory reflects the complex interplay of factors driving currency markets: Federal Reserve policy, fiscal deficits, growth differentials, and political uncertainty surrounding Fed leadership.

"The greenback is likely entering a more prolonged phase of cyclical weakness—not a secular decline," Morgan Stanley analysts noted, distinguishing between temporary pressure and fundamental erosion of the dollar's role.

What's Driving Dollar Weakness

Several forces have converged to pressure the dollar:

  • Fed rate cuts: The Federal Reserve cut rates three times in 2025, bringing the benchmark to a range of 3.50%-3.75%. Markets expect additional cuts in 2026, which narrows the interest rate differential that has traditionally supported dollar strength.
  • Fiscal concerns: Persistent federal deficits and rising debt levels have raised questions about long-term dollar sustainability, even if the currency's reserve status remains secure.
  • Leadership transition: President Trump is expected to name a successor to Fed Chair Jerome Powell early this year. The transition introduces uncertainty about future monetary policy direction.
  • Growth slowdown: Slowing U.S. economic growth relative to other regions reduces the dollar's relative appeal to international investors.

What Supports the Dollar

Despite these headwinds, structural factors continue to underpin dollar strength:

IMF reserve data shows the dollar at approximately 56.92% of global foreign exchange reserves in Q3 2025. Bank for International Settlements data reveals the dollar on one side of roughly 89.2% of global currency trades. These metrics highlight the dollar's continued dominance in international finance—a status that won't change quickly regardless of cyclical pressures.

Additionally, the dollar retains its safe-haven appeal during periods of market stress. If global economic conditions deteriorate or geopolitical risks escalate, money typically flows back into dollar-denominated assets.

Portfolio Implications

For U.S. investors, dollar weakness has mixed effects:

  • International stocks: A falling dollar boosts returns from foreign equities when translated back to U.S. currency. Investors with unhedged international exposure may benefit.
  • Commodities: Dollar weakness typically supports commodity prices, as many raw materials are priced in dollars. Gold, oil, and industrial metals may find a tailwind.
  • Multinational corporations: U.S. companies with significant overseas revenue benefit from currency translation effects, while importers face higher costs.
  • Emerging markets: Developing economies with dollar-denominated debt find their burdens easier to service when the dollar weakens, potentially supporting emerging market assets.

Trading the Volatility

Morgan Stanley's forecast of a decline followed by a rebound presents opportunities for tactical traders—but also risks. Currency moves are notoriously difficult to time, and the factors driving the dollar can shift rapidly based on economic data, policy statements, and geopolitical developments.

For most investors, the prudent approach is to ensure portfolio diversification accounts for currency exposure rather than attempting to profit from short-term swings. Those with concentrated dollar positions might consider gradually increasing international diversification, while investors already well-diversified may simply ride out the volatility.

The Bottom Line

The dollar's 9.4% decline in 2025 marked a significant shift in currency markets after years of strength. While Morgan Stanley and other forecasters see more weakness ahead in early 2026, they don't envision a collapse in the dollar's fundamental role. The currency that underpins global trade and serves as the world's reserve isn't going away—but its value will fluctuate more than many investors have recently experienced.

For 2026, expect volatility. The dollar's rocky road may create opportunities for those positioned to capitalize on the swings—and challenges for those caught off guard.