The U.S. dollar just closed out its worst year since 2017, falling more than 9% against a basket of major currencies. And according to Morgan Stanley, the pain isn't over—the bank sees further weakness ahead before an eventual rebound in late 2026.

Morgan Stanley's currency strategists project the U.S. Dollar Index (DXY) will decline from current levels around 100 to approximately 94 by the second quarter of 2026. That would represent the dollar's lowest level since 2021 and mark a continuation of the greenback's slide from its 2022 peak above 114.

Why the Dollar Is Weakening

Several factors are driving the dollar's decline, and most of them aren't going away anytime soon:

Federal Reserve Rate Cuts: The Fed cut rates three times in 2025, bringing the policy rate to a range of 3.50%-3.75%. With at least two more cuts expected in 2026, the interest rate differential that previously supported dollar strength is narrowing.

Persistent Overvaluation: Despite the recent decline, the dollar remains overvalued by most measures. According to Bank for International Settlements data, the dollar's broad real effective exchange rate stood at 108.7 in October—only slightly below its record peak of 115.1 in January. Both purchasing power parity and fundamental model estimates suggest further downside.

Fiscal Concerns: The U.S. fiscal picture continues to deteriorate, with the deficit and national debt raising questions about long-term sustainability. While the dollar retains its reserve currency status, persistent fiscal imbalances create headwinds.

Global Diversification: Central banks worldwide have been gradually diversifying reserves away from the dollar—not dramatically, but steadily. IMF data shows the dollar's share of global reserves at 56.92% in Q3 2025, down from nearly 72% two decades ago.

The Case for a Late-Year Rebound

Morgan Stanley doesn't see dollar weakness as a one-way trade. The bank projects the dollar index recovering to 100 by year-end 2026, driven by several factors:

Fiscal Stimulus Effects: The "One Big Beautiful Bill" and other fiscal measures passed in 2025 are expected to boost economic growth, which could support the dollar once the effects materialize.

Fed Pause: If the Fed completes its cutting cycle by mid-year and signals a pause, the interest rate differential may stop widening, removing one source of dollar pressure.

Relative Economic Performance: While the U.S. economy faces headwinds, growth remains stronger than in Europe and Japan. Economic outperformance historically supports currency strength.

What Dollar Weakness Means for Investors

For U.S.-based investors, a weaker dollar has significant portfolio implications:

International Equity Returns: Dollar weakness boosts returns on foreign investments when translated back to U.S. dollars. A European stock that's flat in euro terms could show gains of 5-10% in dollar terms if the currency moves as Morgan Stanley projects.

Commodity Prices: Most commodities are priced in dollars, so a weaker greenback tends to support commodity prices. This benefits holders of gold, oil, and other natural resources.

Multinational Earnings: U.S. companies with significant international revenue benefit from dollar weakness, as overseas profits translate into more dollars. Tech giants like Apple, Microsoft, and Google could see meaningful earnings tailwinds.

Inflation Implications: A weaker dollar makes imports more expensive, which could complicate the Fed's inflation fight. This is one reason the Fed watches currency movements closely.

Alternative Views

Not every forecaster shares Morgan Stanley's vision. ABN AMRO also expects dollar weakness, projecting EUR/USD reaching 1.18 over the next 12 months. J.P. Morgan Global Research remains "bearish on the dollar for 2026" while being "moderately bullish on the euro."

However, dollar bulls point to several factors that could limit the decline:

  • The dollar's safe-haven status during periods of market stress
  • Relative economic strength versus other major economies
  • The potential for "higher for longer" rates if inflation proves sticky
  • Geopolitical uncertainty that typically benefits dollar holdings

Portfolio Positioning Considerations

For investors concerned about dollar weakness, several strategies merit consideration:

  • International Equity Exposure: Increasing allocation to non-U.S. stocks can benefit from both local market returns and currency translation gains.
  • Commodity Allocation: Gold and other commodities often perform well during periods of dollar weakness.
  • Currency-Hedged Funds: For those who want international exposure without currency risk, hedged ETFs are available.
  • Multinational Stocks: U.S. companies with significant overseas revenue can serve as a domestic way to benefit from dollar weakness.

The Bigger Picture

Despite the near-term weakness, the dollar's fundamental position as the world's reserve currency remains secure. The greenback still dominates global trade, central bank reserves, and financial transactions. What's happening is a reversion from extreme overvaluation, not a structural crisis.

For long-term investors, currency movements tend to be cyclical and mean-reverting. The dollar's decline from 2022 peaks is notable but not unprecedented. What matters more is building a diversified portfolio that can withstand currency fluctuations in either direction.

The Bottom Line

Morgan Stanley's forecast of dollar weakness through mid-2026 followed by a recovery adds nuance to the currency outlook. For investors, the key takeaway isn't to make big directional bets on currency movements, but rather to ensure portfolios are appropriately diversified across geographies and asset classes.

A weaker dollar creates both opportunities and challenges. International investments become more attractive, commodity-linked assets may benefit, and multinational company earnings could get a boost. But imported goods become more expensive, and inflation risks remain. As always, balance is key.