Morgan Stanley: US Dollar Outlook - Depreciation Path Under Tariff and Fiscal Risks
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Morgan Stanley argues that US tariff policies and expanding fiscal deficits will jointly push the US dollar into a depreciation cycle. The firm forecasts the US Dollar Index (DXY) will decline 5% to 8% by the end of 2026, reaching a target of 95, primarily due to retaliatory tariffs from trade partners and domestic fiscal tightening. The report stresses that markets are underestimating the negative impact of tariffs on economic growth, estimating a 0.5 percentage point drag on GDP, while the capacity for fiscal stimulus remains limited. Consequently, the Federal Reserve may be forced to cut interest rates by 50 basis points in the second half of 2026 to mitigate economic slowdown, further weakening the dollar. The greenback is currently overvalued by approximately 10%, with its real effective exchange rate at historical highs, intensifying mean-reversion pressures. The euro and the Japanese yen are expected to be the primary beneficiaries, with EUR/USD projected to rise to 1.15 and USD/JPY to fall to 130, supported by Eurozone fiscal expansion and Bank of Japan policy normalization. Emerging market currencies will likely diverge: the Mexican peso and Korean won face pressure from trade exposure, whereas the Indian rupee remains relatively stable. In a risk scenario where tariff negotiations collapse, the dollar could experience a sharp decline exceeding 10%.
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