The U.S. dollar is mounting a quiet comeback. After declining more than 9% in 2025—its steepest annual drop since 2017—the Dollar Index (DXY) has rallied for four consecutive sessions to start 2026, climbing to 98.98 on Friday. While still far from its early 2025 highs above 110, the greenback's nascent recovery has caught currency traders' attention.

Anatomy of the 2025 Collapse

To understand where the dollar might be headed, it's essential to understand what drove its sharp decline. Several forces conspired against the greenback last year:

Interest Rate Differentials Narrowed

The Federal Reserve cut rates three times in late 2025, bringing the federal funds rate from 5.25-5.50% to 3.50-3.75%. Meanwhile, other major central banks—particularly the European Central Bank and Bank of England—maintained relatively higher rates, reducing the yield advantage that had supported dollar strength.

Fiscal Concerns Mounted

Persistent U.S. budget deficits and ballooning national debt raised questions about long-term dollar stability. With annual deficits exceeding $2 trillion and total debt approaching $39 trillion, some international investors diversified away from dollar-denominated assets.

De-dollarization Discussions

Geopolitical tensions and BRICS expansion renewed discussions about reducing dollar dominance in international trade. While practical de-dollarization remains limited, the narrative contributed to sentiment pressure on the currency.

Trade War Uncertainty

The Trump administration's aggressive tariff policies created uncertainty that paradoxically weakened the dollar. While tariffs can theoretically support currencies by reducing imports, the broader economic uncertainty and potential retaliation risks outweighed these effects.

What's Changed in 2026

The dollar's four-day rally reflects a shift in several key dynamics:

Fed Cut Expectations Fading

Friday's employment report—showing resilient job gains and declining unemployment—effectively eliminated any possibility of a January Fed rate cut. Market pricing now suggests the Fed may deliver fewer cuts in 2026 than previously expected. Higher-for-longer U.S. rates support the dollar.

"The unemployment rate unexpectedly edging down to 4.4% effectively ruled out a January rate cut by the Fed."

— Market analysis

Relative Growth Dynamics

While U.S. growth has moderated, it remains stronger than many developed-market peers. The eurozone continues struggling with anemic expansion, Japan's recovery remains fragile, and China faces structural headwinds. This relative outperformance supports dollar demand.

Technical Support Holds

The Dollar Index tested key support around the 97-98 level multiple times in late 2025 without breaking down. Each test attracted buyers, establishing a floor that technical traders now view as significant. The successful defense of this zone has encouraged momentum buying.

Risk-Off Episodes

Periodic volatility in global markets—including concerns about China's property sector and European political uncertainty—has triggered safe-haven flows into dollars. The greenback retains its status as the world's reserve currency and destination for flight-to-safety capital.

The Bull Case for 2026

Dollar bulls argue several factors could drive further gains:

  • Inflation persistence: If U.S. inflation proves stickier than expected, the Fed will maintain restrictive policy longer, supporting the dollar
  • Growth divergence: American economic exceptionalism—driven by AI investment and fiscal stimulus—could widen versus other major economies
  • Technical momentum: A decisive break above 100 on the DXY could trigger systematic buying and short-covering
  • Tariff implementation: Actual enforcement of threatened tariffs could reduce imports and theoretically support the currency

The Bear Case

However, significant headwinds remain:

  • Twin deficits: America's current account and fiscal deficits create structural dollar supply that pressures the currency over time
  • Fed easing bias: Even if cuts are delayed, the Fed's direction is toward easier policy—not tighter
  • Valuation: By most metrics, the dollar remains overvalued versus long-term purchasing power parity estimates
  • Diversification trends: Central bank reserve managers continue gradually diversifying away from dollar holdings

Sector and Asset Implications

Dollar movements create winners and losers across the investment landscape:

A Stronger Dollar Benefits:

  • Importers: Companies buying goods abroad see costs decline in dollar terms
  • U.S. consumers: Import prices fall, supporting purchasing power
  • Domestic-focused companies: Firms with limited international exposure avoid translation headwinds
  • Treasury holders: Foreign investors in U.S. bonds see currency gains atop yield returns

A Stronger Dollar Hurts:

  • Multinational exporters: American goods become more expensive abroad, pressuring sales
  • S&P 500 earnings: Approximately 40% of S&P 500 revenue comes from overseas; translation effects reduce reported earnings
  • Emerging markets: Dollar-denominated debt becomes harder to service; capital outflows accelerate
  • Commodities: Dollar-priced commodities become more expensive for foreign buyers, reducing demand

The Forecaster Consensus

Currency strategists offer divided opinions on the dollar's 2026 trajectory:

  • Bullish view: DXY could rally toward 102-105 if the Fed maintains restrictive policy while other central banks ease
  • Bearish view: The dollar likely resumes its decline toward 92-95 as deficit concerns intensify and global growth rebalances
  • Consensus range: Most forecasts cluster between 92 and 98, with a bias toward the low 90s by year-end

Many strategists describe a "V-shaped" year: dollar weakness in the first half as the Fed cuts rates, followed by potential recovery in the second half if inflation surprises or global conditions deteriorate.

Practical Implications for Investors

For U.S.-based investors, currency movements affect portfolios in several ways:

International Equity Exposure

A strengthening dollar reduces returns on unhedged international equity funds. The local currency return of foreign stocks is diminished when translated back into appreciating dollars. Conversely, a weaker dollar enhances international returns.

Multinational Earnings

Large-cap U.S. multinationals—including technology giants with significant overseas revenue—face earnings headwinds from dollar strength. Domestic-focused mid-caps may outperform in a strong-dollar environment.

Emerging Market Exposure

Dollar strength typically pressures emerging market assets as capital flows toward the United States. EM debt and equity positions may underperform during dollar rallies.

The Bottom Line

The dollar's early 2026 rebound from its worst year since 2017 reflects shifting rate expectations and relative economic dynamics. Whether this rally extends into a sustained recovery depends on inflation data, Fed policy, and global growth patterns that remain highly uncertain.

For investors, the key insight is that currency movements increasingly matter for portfolio returns. After years of dollar stability, the volatility of 2025 and early 2026 demonstrates that the greenback can move meaningfully in either direction—creating both risks and opportunities across asset classes.

The dollar's direction in 2026 will likely be determined by a fundamental question: Is American economic exceptionalism sustainable, or will the rest of the world catch up? The currency market's answer will shape returns across global portfolios.