The US dollar may be at an inflection point – but is it really time to expect sustained weakness? Recent moves in currency markets suggest that the forces behind exchange rates may be shifting. However, the causes are not directly related to interest rate developments. Rather, it is capital flows that have provided the fundamental basis for the recent movements in the EUR/USD exchange rate.
USD Performance in Recent Months
In mid-January 2025 the USD reached a level of 1.0275 EUR/USD. At this point, a number of market indicators suggested that a fall to 1.05 EUR/USD was in the cards. This is exactly what happened – the USD fell to 1.05, recovered briefly to 1.04 and then broke through resistance at 1.0525 with great momentum. This breakthrough was largely due to the closing of short positions, which created additional selling pressure. The USD is currently trading at just over 1.08 against the Euro.
It is interesting to note, however, that this movement was not due to a fundamental change in the interest rate environment:
- Interest rates in the eurozone were clearly on a downward trend.
- In the US, on the other hand, only a small or no further rate cut was expected in 2025.
So if interest rates did not cause exchange rate movements, what did?
Capital Flows as a Driving Force Behind Changes in the Exchange Rate
It is capital flows that are driving the structural changes in currency markets, not interest rates. In the last two issues of last year and the first reports of this year, I pointed out that the immense US budget deficits of the past 15 years have laid the foundation for the consumption-driven stock market boom in the US.
The surge in US equity markets has attracted huge inflows of capital from abroad:
✅ The average American investor had only about 44% of his liquid assets invested in equities a few years ago – today it is a whopping 70%.
✅ By February 2025, the US accounted for 73% of global stock market capitalisation – an unprecedented level by historical standards.
However, these capital flows are now beginning to shift – and this is where the current and future exchange rate changes are coming from.
Stock Market Volatility – Capital Flight From the US?
Since the beginning of 2025, a paradigm shift has been underway:
- European stock exchanges began to distance themselves from US assets.
- While the Nasdaq lost 10% last month, the DAX gained a further 3%, having already gained 11% between the beginning of the year and the end of February.
Two key factors have driven this development:
- Policy uncertainty under the new Trump administration – The Trump administration has created uncertainty in the markets with its protectionist trade policies and regulatory interventions.
- Relative valuation advantages of European markets – While US equity markets remain richly valued, European markets continue to offer cheap entry opportunities (“value assets”).
The result has been an increasing shift of capital from the US to European markets – and it is these capital movements that explain the recent strength of the euro.
Why the USD May Not Remain Weak for Long
Despite the current period of USD weakness, there are several reasons why a sustained devaluation may not materialise:
🔹 The US economy remains resilient – in particular due to stable consumption and continued high profitability in the technology sector.
🔹 The geopolitical situation – particularly with regard to Ukraine and China – could again trigger a safe-haven flight to the USD.
Conclusion: Capital Flows Determine the Exchange Rate – Not Interest Rates
The recent weakness of the USD is less a sign of structural weakness in the US economy than the result of a reassessment of capital flows. The relative undervaluation of European markets, coupled with increasing political uncertainty in the US, has led to a flight of capital out of US equities – and this has pushed up the EUR/USD exchange rate.
However, sustained USD weakness remains questionable as long as the interest rate differential persists and the US economy does not lose its structural strength. The dynamics of capital flows will therefore determine whether the EUR/USD exchange rate can continue its upward trend – or whether the USD will return to strength in the second half of the year.
At the time of the NASDAQ sell-off (yellow above), the euro and the JPY began to rise against the USD, each by just under 5%. At a time when US interest rates were “positive” for the USD relative to expectations for euro interest rates. Interest rates may or may not coincidentally also indicate USD strength, capital flows ALWAYS lead the way.
