The dollar's Warsh moment

The US Dollar Index jumped sharply in a single day after Kevin Warsh was formally nominated as Federal Reserve chairman. Currency traders promptly named the move 'the dollar's Warsh moment'. It reversed part of a long slide: in the first half of 2025 the index had its worst first half since 1973, as tariffs, worries about the budget deficit and attacks on the Fed's independence drove investors out of the currency.

The comparison with 1973 is apt for reasons beyond the numbers. That was the year the major currencies began to float after the collapse of the Bretton Woods system, and the dollar fell because the rules that anchored it had been torn up. The slide of 2025 had a similar flavour, since investors were selling doubts about American institutions as much as they were selling a rate differential.

How the debasement trade was built

The bet against the dollar rested on a simple story. A president who wanted much lower interest rates, a large and persistent federal deficit, and public pressure on the Fed's governors, culminating in the attempt to remove Governor Lisa Cook in August, suggested a central bank that would let inflation run to ease the government's debt burden. Investors expressed that view by selling dollars, buying gold and other precious metals, and cutting the currency hedges on their American assets. Precious metals, the purest form of the trade, fell hard on the day of the nomination.

Gold had been the clearest scoreboard. It set a string of record highs through 2025, helped by central banks that had been adding to their reserves since Western governments froze Russia's reserves in 2022 and showed that dollar assets could be immobilised. Those official buyers are slow to change course, but the leveraged money that piled in on top of them is not, which is why the metal fell so quickly once the story changed.

The hedging leg matters most for the speed of the reversal. When a European pension fund or a Japanese insurer raises the hedge ratio on its American bonds, it sells dollars forward without selling a single Treasury, and when it lowers the ratio again it buys them back. Flows of that kind can turn within days, because they require no decision about the underlying assets, and that helps explain why a single nomination moved the index so far.

Fewer dollars to go round

The rally shows currency markets working through what Warsh's views imply for policy. If a Fed under Warsh shrinks its multi-trillion-dollar balance sheet quickly, the supply of dollar reserves around the world will fall sharply. Less Fed money means less dollar liquidity abroad, and a scarcer dollar is worth more against other currencies. The link runs through the banks: as reserves shrink, dealers have less balance sheet to lend dollars to foreign banks and companies, and the premium those borrowers pay in the currency swap market tends to rise.

That premium has spiked before when dollars ran short. In the autumn of 2008 and again in March 2020, foreign banks scrambling for dollar funding drove the cross-currency basis sharply wider, and the Fed had to open or enlarge swap lines with other central banks to calm the market. A slow, deliberate shrinkage would not produce anything so violent, but it would push in the same direction.

Credibility comes back into the price

Warsh is also known as a firm critic of central banks bending to government borrowing needs, and that reassured foreign investors about American creditworthiness. Reserve managers who had spent twelve months on the 'debasement trade' had to buy back large bets against the dollar. A former governor who left the Fed partly over its second round of bond buying is a hard figure to cast as the man who will monetise the deficit.

History suggests that the person in the chair can move a currency for years. When Paul Volcker took over in 1979 and made clear he would squeeze inflation out whatever the cost, the dollar began a climb that lasted until finance ministers agreed at the Plaza Hotel in 1985 to push it down. Nobody expects a repeat on that scale, since Volcker drove real rates to extremes, but the episode shows that credibility is priced into exchange rates along with yields.

Who pays for a stronger dollar

A firmer dollar redistributes gains around the world. Emerging-market borrowers with dollar debts face higher repayment costs in their own currencies, and the precedent is uncomfortable: in 2018, when the Fed was raising rates and shrinking its balance sheet at the same time, Argentina and Turkey both suffered currency crises. American multinationals lose on the translation of foreign profits, while European and Japanese exporters gain. Holders of gold, and of the currencies that rallied most as the dollar fell, are the obvious losers from any further unwinding.

The euro deserves particular attention, because it makes up more than half of the Dollar Index, so a rebound in the index is largely a verdict on the dollar against the single currency. European exporters would welcome relief after a year of a strong euro, while the European Central Bank would lose some of the disinflationary help that a firm exchange rate had provided.

Rate cuts pull the other way

The strongest argument against a lasting dollar recovery is that Warsh was nominated to deliver lower interest rates. Currencies respond to the gap between short-term rates at home and abroad, and a Fed cutting faster than the European Central Bank or the Bank of Japan would narrow the yield advantage that has supported the dollar. If the balance sheet shrinks slowly, because bank reserves cannot fall far without disrupting money markets, the rate cuts could dominate and the dollar would give back its gains.

The signals to watch are Warsh's confirmation hearing and any timetable he offers for reducing the balance sheet, the cross-currency basis in the swap market, foreign demand at Treasury auctions, and the price of gold. Currency markets reward a central bank that shrinks its balance sheet. If Warsh does what traders expect, the dollar probably has further to recover, and the debasement trade will keep unwinding.