Author: vivienna.btc; Source: X, @viviennaBTC

Over the past year or so, do you have a feeling that even though the Federal Reserve has cut interest rates, why is the U.S. dollar still strengthening? Although the economic data is obviously very strong and there are obvious expectations of suspending interest rate cuts, the US dollar is actually weakening? Has the interest rate differential logic of U.S. dollar pricing changed fundamentally? How far has de-dollarization gone?

We review the changes in the US dollar since 2025 to sort out the changes in its pricing logic.

In order to more fully understand the factors that influence the value of the U.S. dollar, we can break it down into the following core dimensions.

1. Core pricing factors

The traditional logic of interest rate parity still exists, but now the dollar needs to be observed within a broader framework:

• Spread compensation (rate): Determines the nominal return on holding U.S. dollar assets, mainly affected by Fed policy expectations.

• Risk premium (risk): The required return for policy and institutional uncertainty (such as tariff policy, fiscal fluctuations). When uncertainty rises, risk premiums increase, potentially causing the dollar to weaken.

• Convenience income (cy): Reflects the premium investors pay for the safety, liquidity, and collateral properties of the U.S. dollar. It can also be regarded as the safe-haven property of the US dollar.

We can think of the required rate of return for foreign investors holding U.S. dollar assets as the combined force of three factors:

It essentially reflects investors’ willingness to hold U.S. dollars: If you want me to hold U.S. dollars, the coupon interest (Rate) you give me must be deducted from the risk I worry about (Risk), plus the convenience it brings me (CY). If the final result is not up to standard, I will sell the U.S. dollar and cause its depreciation.

We often see the interest rate differential logic and it is easy to quantify and understand: the higher the interest rate differential between the US dollar and other currencies, the higher the nominal rate of return on US dollar assets should be;

The risk premium is also easy to understand: When the risk premium rises, the total rate of return required by investors increases. If nominal interest rates do not rise fast enough, the dollar exchange rate must fall (depreciate) to create room for future appreciation, thus compensating investors for their uneasiness.

More difficult to understand and quantify are convenience benefits.

We can understand this as investors being willing to sacrifice a portion of the rate of return for these conveniences, so it is a minus term in the formula. This is the non-coupon benefit provided by the U.S. dollar as a safe asset, including its liquidity, properties as collateral, and convenience of settlement networks, among others.

According to the formula, when convenience benefits fall, the dollar is likely to fall even if interest rate spreads widen and risk premiums rise.

For example, the emergence of mBridge allows many countries to bypass the U.S. dollar in their economic and trade settlements. Such events are becoming more frequent, and the voice of "de-dollarization" is becoming stronger (note that it is a voice rather than a fact, we will discuss it later). The decline in convenience benefits means that the "safety attribute" of the U.S. dollar is diluted, and investors require higher nominal interest rate differentials to compensate. If the Fed does not raise interest rates at this time (nominal interest rate differentials remain unchanged), the U.S. dollar must create room for future appreciation (i.e., a discount) bya fall in the spot exchange rate, thereby reaching a balance in total returns.

So, how to measure convenience benefits?

In financial markets, convenience benefits can usually be quantified using US Treasury Basis. It refers to the price difference between real U.S. debt and U.S. dollar cash flows synthesized through foreign exchange swaps.

The so-called real U.S. bonds are physical bonds issued by the U.S. government that investors purchase directly in the market.

The US dollar cash flow synthesized through foreign exchange swaps can be understood like this: Suppose a European investor has euros in his hands, and he wants to obtain a return similar to that of U.S. bonds, but he does not buy U.S. bonds directly, but synthesizes it through foreign exchange swaps (FX Swap). The operation method is: investors exchange euros for U.S. dollars, and look for a risk-free U.S. dollar return in the market. In the future (such as 3 months later), the U.S. dollars will be exchanged back for euros at an agreed price.

This perfectly replicates the process of holding U.S. dollar cash flows in terms of financial effect, but it is not a real U.S. government bond, but a contract-based capital transaction.

So why is there a price difference between the two? We need to understand a theoretical concept: CIP (Covered Interest Rate Parity)

CIP is a basic pricing logic in international finance. It believes that in an ideal theoretical world, with free capital flow, the interest rate difference between the two countries should be equal to the forward premium and discount rate between the local currency and the foreign currency. Therefore, the returns of the two should be equal.

But in reality, real U.S. bonds are generally more popular than synthetic assets.

The U.S. Treasury basis is the difference between the two yields. If people are willing to accept lower interest rates than synthetic assets in order to snap up real U.S. debt, the difference reflects how much people pay for that extra convenience and security. The larger the spread, the more willing the market is to pay a premium for real U.S. dollar safe assets.

In short, the spread provides explicit coupon compensation, while cy provides the implicit benefits brought by liquidity and collateral attributes. The two together determine the motivation for overseas investors to hold U.S. dollar assets.

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Understanding how these three core factors affect the U.S. dollar exchange rate, we can see that when these factors change simultaneously, the interest rate differential logic will fail.

For example, if U.S. policy leads to a surge in uncertainty, on the one hand it will push up risk premiums, and on the other hand it may lead to a decrease in the convenience of the U.S. dollar. This will lead to a significant increase in the rate of return required by investors. Even if U.S. bond yields are rising at this time, the U.S. dollar exchange rate may still be under pressure because it is not attractive enough.

In the case of 2025, the switch in this pricing logic is very obvious: the US dollar is no longer a simple high-interest currency, and its pricing is deeply affected by investors' willingness to pay for safety attributes (that is, convenience).

For example, when the United States implemented "reciprocal tariffs" in April 2025, the market volatility VIX surged sharply. At that point in time, the interest rate differential between U.S. bonds and German bonds actually widened by 50 basis points, but the U.S. dollar index fell rapidly by 3.6%.

We can think of the formula as an investor’s mental ledger:

• Interest rate compensation : This is the interest you can get on the surface.

• Risk premium: This is because you are worried about the price increase that the other party wants.

• Convenience income: This is part of the income that you are willing to give up because the asset is easy to use.

In the April 2025 “reciprocal tariff” shock, the situation is very typical:

1. Rising risk premium: Due to the surge in policy uncertainty, the risk perception held by overseas investors has increased, and the required risk premium has increased significantly.

2. Decrease in convenience benefits: When risks originate from the internal policy stability of the United States, the US dollar’s safe-haven properties (convenience benefits) will be alienated, turning from a safe haven into a risk center.

3. Interest spread failure: Even though U.S. bond yields rose by about 50 basis points at that time, this increase was still not enough to cover the additional risk premium demanded by investors due to uneasiness, causing the U.S. dollar exchange rate to fall by 3.6%.

Therefore, the rise in U.S. bond yields during that period was actually driven by the term premium rather than optimistic expectations for economic growth. When the rise in yields is driven by the term premium, it does not reflect a stronger U.S. economy, but rather that investors dare to hold U.S. bonds because they are worried about fiscal policy or policy fluctuations and demand more returns. In this case, although U.S. bond yields are rising, the U.S. dollar exchange rate tends to weaken, resulting in a divergence between the two trends.

2. Foreign exchange hedging behavior determines the transmission efficiency of spread expectations

In addition to the above core pricing factors, even if interest rate spreads and safety are attractive, the final trend of the US dollar also depends on the attitude of funds, that is, foreign exchange hedging behavior.

The transmission mechanism of the foreign exchange market's impact on the value of the U.S. dollar can be simply explained as: If overseas investors buy U.S. dollar assets and at the same time lock in exchange rate risks (i.e., perform hedging) by selling U.S. dollars forward, then the support effect of this capital inflow on the spot exchange rate (spot price) of the U.S. dollar will be significantly weakened. Therefore, hedging behavior determines the transmission efficiency of spread expectations.

For example: If an overseas fund decides to buy US$1 billion in US bonds, but for insurance, they immediately sell US$1 billion forward in the market. In this case, do you think this transaction will have a significant impact on the spot (that is, the current) U.S. dollar exchange rate? The answer is that it will not rise. If the buyer is hedging (i.e. buying the asset and selling forward dollars at the same time), the trade's support for the spot rate will be significantly lessened.

This is because the original power of buying U.S. dollars is offset by selling forward U.S. dollars. This is like buying with your left hand and selling with your right, increasing the selling pressure in the spot market to offset the driving force of capital inflows, causing the traditional logic of capital inflows to support the strength of the US dollar to be very unstable. This also makes the explanatory power of interest rate spreads on spot exchange rates more unstable.

After the long-term appreciation expectations of the US dollar were broken in 2025, this hedging behavior became more normalized, which means that even if US assets are attractive, the US dollar will not necessarily strengthen. This explains why sometimes the carry signal is strong, but the dollar just can’t rise.

So, how do we observe the transmission efficiency of hedging behavior? A key indicator is the co-change in hedging costs and the proportion of foreign hedging.

Hedging costs

When hedging costs fall, investors are more inclined to buy U.S. assets while selling U.S. dollars through forward contracts to avoid risks.

The hedging cost is essentially the difference between the forward exchange rate and the spot exchange rate, so the most direct indicator to measure the hedging cost is the swap point (FX Forward Points, Forward - Spot Spot). The swap point reveals the cost of leasing funds in the foreign exchange market and reflects the interest rate compensation that investors must pay or receive in order to lock in the future exchange rate.

The swap point is mainly affected by the currency interest rate difference between the two countries and market liquidity. Its core logic is based on the interest rate parity theory. Simply put, the swap point does not fluctuate randomly. It is essentially the expression of the interest rate difference between the two currencies in the exchange rate.

The specific way to do this is by looking at the 3-month or 1-year forward premium/discount of the US dollar against major currencies (such as the euro, yen).

For example: The US dollar interest rate is higher than the euro, and the US dollar usually behaves as a "discount" in the forward market, that is, the forward exchange rate is cheaper than the spot exchange rate (Forward < Spot). Because: if the U.S. dollar interest rate is high, everyone will want to hold U.S. dollars. In order to prevent everyone from engaging in risk-free arbitrage by "borrowing euros to buy U.S. dollars", the forward U.S. dollar must depreciate and give back the extra interest.

So, by observing the changes in swap points, we can know the attitude of foreign investors, and you can infer the underlying reasons why the spot exchange rate (Spot) cannot rise:

A. When swap points become more expensive (discount expands):

• Phenomena: The U.S. dollar interest rate spread further widens, or U.S. dollar liquidity tightens.

• Consequences: Overseas investors found that although the yield (interest) on U.S. bonds was high, the net income (Hedged Yield) after hedging exchange rate risk became thinner.

• Conclusion: Investors may reduce their buying or be forced to run naked (without hedging). If they choose not to hedge, the dollar spot rate will strengthen as Treasuries are purchased.

B. When swap points become cheaper (discount narrows):

• Phenomena: Even if the Fed does not cut interest rates, the forward dollar cannot fall due to market fluctuations (such as policy concerns in April 2025).

• Consequences: Hedging costs fall.

• Conclusion: As mentioned before, investors will be more inclined to "buy bonds and hedge at the same time." At this time, even if you see a large amount of foreign capital flowing into the United States, because they sell dollars simultaneously in the forward market, the U.S. dollar index (DXY) will appear "motionless" or "weak" in the spot market.

In addition to swap points, another depth measure of USD hedging costs isCross-Currency Basis Swap.

Under normal circumstances, swap points are driven solely by interest rate differentials. But under extreme risks (such as reciprocal tariff shocks), a currency swap basis (Basis) will arise. Simply put, it is the premium paid (or saved) to borrow a currency through the swap market rather than borrowing the currency directly in the domestic currency market. It is the ultimate stress gauge of the global dollar liquidity crunch.

In the ideal world of finance textbooks (satisfying "covered interest parity" CIP), this basis should be 0. That is, whether you borrow dollars directly or borrow euros and convert them into dollars, the cost should be the same. But in reality, due to various reasons, there is a difference between the two, which is the basis.

The formula for estimating the theoretical hedging cost by deviation from Covered Interest Parity (CIP) is as follows:

Where i represents the risk-free rate of the corresponding period (such as SOFR).

If Basis is negative (negative basis): It means that it is more expensive to obtain U.S. dollars through swaps than to borrow U.S. dollars directly. In fact, basis is basically negative, and the existence of negative basis itself is a manifestation of the failure of covered interest parity (CIP). It reflects the global financial system’s desperate thirst for the convenience of the U.S. dollar, resulting in people being willing to pay an additional premium (i.e., lower euro yields) in exchange for dollars. The deeper the negative basis, the tighter the liquidity of the US dollar.

If Basis is positive: It means it is cheaper to obtain dollars through swaps (this is extremely rare and usually occurs when there is an extreme surplus of dollars).

So, at this time, the actual hedging cost = theoretical spread + Basis.

• Logic: When the Basis becomes more negative (e.g. the EUR/USD Basis expands), it means that it is extremely costly to obtain dollars from overseas and hedge them. This means that even if the interest rate spread does not change, hedging costs will surge because everyone is grabbing US dollar liquidity. This creates a vicious cycle: hedging is too expensive - investors sell Treasuries - term premium rises - U.S. bond yields rise, but the dollar falls due to capital outflows.

• Signal: If the hedging cost is extremely high, foreign investors may choose to streak (without hedging). At this time, buying U.S. bonds will simultaneously push up the U.S. dollar; conversely, if the hedging cost is low, foreign investors will "buy bonds with the left hand and sell forwards with the right hand" as mentioned above, locking in the rise of the U.S. dollar.

Foreign capital hedging ratio

Since there are no official real-time statistics on the hedging ratio in the foreign exchange market (OTC), in reality, no single data can directly tell you the hedging ratio of all foreign capital. We must capture the true intentions of investors through reverse derivation or side confirmation of other public data. For example, you can use the following shadow indicators for high-frequency tracking:

1). The gap between TIC fund flow and the US dollar index (TIC Data vs. DXY)

This is the most macroscopic shadow indicator.

• Observation Point: The TIC (International Capital Flows) report released monthly by the U.S. Treasury Department focuses on the net purchases of medium- and long-term U.S. debt by overseas private investors.

• Logic (strong support): TIC net buying increased sharply + the U.S. dollar index strengthened simultaneously - low hedging ratio (foreign capital actually bought U.S. dollars in the spot market).

• Shadow Signal: TIC net buying increased sharply + the U.S. dollar index weakened or moved sideways - high hedging ratio (foreign investors bought U.S. bonds, but hedged their long U.S. dollar positions through derivatives, that is, buying with the left hand and selling with the right).

2). CFTC Institutional Position Term Mismatch (Commitment of Traders)

Observe the Chicago Mercantile Exchange (CME) foreign exchange futures position report.

• Observation Point: Pay attention to the long positions of "Asset Manager/Institutional" in major non-US currency futures such as the euro and the yen.

• Shadow Signal: If these institutions are increasing their positions in the U.S. Treasury market and at the same time buying large amounts of non-U.S. currency futures in the futures market (equivalent to selling forward dollars), this directly reflects that they are conducting exchange rate hedging for the spot assets they hold.

3). Cross-Currency Basis Swap

This is both a cost indicator and a shadow of behavior.

• Observation Point: 3M or 1Y EUR/USD, JPY/USD Basis.

• Logic: The more negative the Basis is (the deeper it falls), it means that the market is extremely hungry for US dollars, or the cost of locking in US dollar risks is extremely high.

• Shadow Signal: If Basis continues to hover in the extremely negative range, it means that even if foreign investors want to hedge, the cost may prohibit them. If the U.S. dollar still does not rise at this time, it means that foreign investors have simply reduced their allocation to U.S. debt, or are looking for alternative safe assets other than the U.S. dollar.

4). Custodian Flow Data (Custodian Flow Data)

This is the closest to real internal data, typically published in research briefings by large custodian banks (e.g., State Street, BNY Mellon).

• Observation point: Institutional investors’ “Hedging Appetite” index.

• Shadow signals: These banks directly control trillions of dollars in cross-border settlements. If the report shows that the hedging ratio of "Real Money" (referring to long-term funds such as pension funds and sovereign funds) is at a historically high level, then even if the U.S. bond interest rate spread is higher, the spot exchange rate of the U.S. dollar will be difficult to generate explosive power.

3. The composition of yields affects the direction of the US dollar

Another important reason why spread logic sometimes fails is the structural changes in U.S. bond yields.

Thinking deeply about the linkage logic between U.S. bond yields and the U.S. dollar exchange rate, we can find that the causes of yields determine the direction of the U.S. dollar.

First, when rising yields are driven by short-term interest rate expectations, it is usually a sign of strong fundamentals. It means that the U.S. economy is growing faster than expected, inflation is resilient, or the Federal Reserve is showing a hawkish stance in order to curb overheating. In this case, capital will flow into the United States in pursuit of higher and safer deterministic returns, thus forming a strong momentum to benefit the US dollar.

However, when the rise in yields results from a rise in term premium, its nature changes from a growth dividend to a risk compensation. This reflects market concerns about runaway fiscal deficits, increased policy volatility or geopolitical uncertainty. At this time, investors are not buying because they are optimistic about the U.S. economy, but are demanding higher premiums because they are afraid of future risks. This kind of doubt on sovereign credit and policy stability is essentially an erosion of the gold content of the currency. Therefore, not only is it unable to support the exchange rate, but it often balances this risk cost by being negative for the US dollar.

So we can conclude:

• If U.S. bond yields rise due to short-end interest rate expectations, it is usually bullish for the U.S. dollar.

• If it comes from term premium, it reflects the market's concerns about fiscal or policy risks, which is often negative for the US dollar.

4. The global macro backdrop leads to a passive strengthening of the US dollar

This is easier to understand. We all know the composition of the US dollar index, so political or fiscal disturbances in non-US economies (such as Europe) will passively strengthen the US dollar as a relative price.

In the game of macro-finance, exchange rate is essentially a difference game. The strong position of the U.S. dollar is often not entirely due to the outperformance of the U.S. economy, but is more of a relative premium for hedging risks. When non-U.S. economies such as Europe experience political turmoil (such as election deadlock, geopolitical conflicts) or fiscal imbalances (such as debt pressure, budget overspending), the market's credit expectations for the region's currencies will deteriorate rapidly.

Since the foreign exchange market reflects the relative prices between currencies, when major currencies such as the euro and the pound fall into recession concerns or liquidity contraction due to internal disturbances, global capital will instinctively flow to the most liquid and safe U.S. dollar assets for hedging purposes. This "passive strengthening" reveals a cruel logic: Even if the U.S.'s own fundamentals are mediocre, as long as other major economies perform worse, the U.S. dollar will automatically gain appreciation momentum based on its relative weight. At this time, the US dollar is not so much being sought after because it is getting better, but rather passively pushing up its value as the ultimate antidote to the global financial system.

5. Sentiment factor - "de-dollarization"

We mentioned above that the stronger the voice of "de-dollarization", the lower the convenience benefits. However, "de-dollarization" is not necessarily a fact. It is just an emotion that can affect the value of the dollar.

As traders (especially those who pay attention to the foreign exchange market), you should understand that "de-dollarization" is a long-term slow variable. It involves deep migration at the system level such as trade pricing, cross-border payments, and foreign exchange reserve structure. Its verification usually requires data observation spanning several years.

Against the backdrop of a highly concentrated global supply of safe assets, it is difficult to quickly “de-dollarize” existing funds. In the supply pattern of global safe assets (Safe Assets), U.S. Treasury bonds have an absolute size advantage, with a circulation scale of approximately US$31.5 trillion. Globally, the pool of alternative assets that offer equivalent depth, liquidity and collateral capabilities is significantly smaller. U.S. debt is not only an investment product, but also the underlying structure of the global financial system, playing a core role in cross-border settlement, large-amount financing hedging and liquidity management.

In contrast, the divergence between the US dollar and interest rate differentials in 2025 is more driven by the short-term fast variable of "convenience gains".

Convenience benefits reflect the willingness of marginal funds to pay for the security attributes of the U.S. dollar (such as liquidity, collateral features) within a specific window, and this willingness may fluctuate or repair quickly within a few days. For example, the phased reduction of convenience income in April 2025 and its return in July.

Due to the lack of substitutes, the more feasible approach for the market is not to move away the stock (that is, clearing out US dollar assets), but to change marginal behavior. This dilemma can be compared to a huge reservoir: even if the water quality makes you unsatisfied (policy uncertainty), but because there are no other large enough reservoirs around that can hold so much water (the depth of alternative assets is not enough), you can only stay where you are, but you will reduce the risk by adding filters (exchange rate hedging).

Therefore, if this short-term risk premium revaluation at the transaction level is misinterpreted as long-term structural changes, investors may fall into the risk of unilateralization in strategic judgment.

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To summarize, since traditional logic is no longer sensitive, we need to use new indicators to predict the performance of the US dollar in 2026. Here are three ideas for everyone:

1. Price Signals: Observe U.S. bond basis or cross-currency basis to see investors’ latest evaluation of the U.S. dollar’s convenience benefits.

2. Hedging costs : Observe changes in the hedging ratio to see if funds are still systematically avoiding U.S. dollar risk.

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4. : See whether the rise in U.S. bond yields is due to economic growth expectations or term premium (risk compensation).