New Year's Eve: How the dollar lost its shine

The Dollar Index ended the year down 9 per cent, the greenback's worst twelve months since the aftermath of the global financial crisis. Currency desks raised a glass on New Year's Eve to the end of a rough year, and to the dollar's lost aura.

A penalty for policy

The slide had little to do with the business cycle. Markets were charging for Washington's choices: emergency tariffs imposed by executive order, financial sanctions used as a weapon, an attempt to remove sitting Fed governors and $2 trillion budget deficits. None of that sits easily with a currency meant to be free of risk. Central bank reserve managers cut their dollar holdings to twenty-year lows.

The usual drivers of the exchange rate pointed the other way for much of the year. American growth held up better than Europe's, and the Fed kept its policy rate above the European Central Bank's throughout. On the textbook model those facts should have supported the dollar. The currency fell anyway, and the largest drops came around political events, such as the April tariff announcements and the summer attacks on the central bank, rather than around economic data. That pattern is what separates a risk premium from an ordinary cyclical move.

The privilege at stake

In the 1960s the French finance minister Valéry Giscard d'Estaing called the dollar's role an exorbitant privilege, and the phrase still describes the mechanism. Because foreign central banks, companies and investors want safe dollar assets, the American government can borrow more, and more cheaply, than its fiscal record alone would justify. The demand keeps Treasury yields lower than they would otherwise be and lets the country run persistent trade deficits without a currency crisis.

A risk premium eats into that privilege. If foreign buyers demand a higher return to hold Treasuries, or insist on hedging their currency exposure, the government's borrowing costs rise at the margin. That matters more than it used to: net interest payments on the federal debt now exceed what Washington spends on defence. Each rise in the premium adds to a bill that already grows automatically as old debt is refinanced at higher rates.

Still used, less trusted

The dollar still dominates trade settlement, mostly because there is no liquid alternative. As a safe store of value it has taken lasting damage. Money is being routed through new regional payment channels and into assets priced in other currencies.

The distinction between those two roles is the heart of the matter. As a medium of exchange the dollar benefits from network effects: it sits on one side of almost nine in ten foreign-exchange trades, according to the Bank for International Settlements' triennial survey, because traders converting any two minor currencies find it cheaper to go through the dollar. Those habits change slowly. The store-of-value role is different, because it depends on trust in the institutions that stand behind the currency, and trust can be withdrawn by a reserve manager in a single portfolio review.

The alternatives are growing at the edges. China's cross-border interbank payment system gives banks a route for yuan settlement outside the Western messaging network, and trade between Russia and its large customers has shifted heavily into their own currencies since 2022. None of these channels threatens the dollar's overall position, but together they reduce the share of world trade that sanctions can reach.

How reserve currencies fade

Sterling offers the historical guide. Britain's currency dominated world finance before the first world war, but its decline as a reserve asset stretched over decades, through two world wars and a series of devaluations, and sterling still made up a large share of official reserves into the 1950s. The decline was gradual because reserve managers moved only when a credible alternative existed and when losses on sterling became impossible to ignore. The dollar's erosion, if that is what is under way, is likely to be similarly slow and uneven, marked by episodes like this year's rather than a single break.

The case against decline

The strongest objection is that the dollar has no serious rival. The euro area lacks a single, deep government bond market of the kind that reserve managers need, China's capital controls rule out the yuan as a free store of value, and gold, for all its appeal, pays no interest and cannot be used to settle most trade. The dollar's reach may even be widening in one area: the stablecoin law signed in July encourages private tokens backed by Treasury bills, which could create a new source of demand for American debt.

That objection explains why the dollar has not collapsed, and why it is unlikely to. It does not explain away this year's move. Reserve managers do not need a single replacement to diversify; they can hold a little more gold, a little more euro debt and a few more currencies at once. The result is a dollar that remains central but has to pay more to keep its place.

Who feels it

The costs fall first on the American Treasury and on households paying more for imports. Countries that peg their currencies to the dollar, including the Gulf oil exporters, import American monetary policy whether or not it suits them, and a weaker dollar has eased financial conditions across emerging markets that borrow in it. European and Japanese exporters lose competitiveness in the American market.

Signals for the new year

The indicators to watch are the foreign share of demand at Treasury auctions, the monthly Treasury data on international capital flows and the IMF's quarterly figures on reserve composition. The appointment of a new Fed chair and the Supreme Court's hearing on the attempt to remove Governor Lisa Cook will show how far the central bank's independence can be pressed.

The dollar goes into 2026 as the currency of a heavily indebted government, and investors will probably demand a higher risk premium to hold it. The New Year's Eve 2025 close marks the end of its easy exceptionalism. The first test will come in the first half of the year, when a Fed chair seen as close to the White House would likely push term premiums up and the dollar down further.