The USD is likely to remain under pressure despite the potential for short-term rallies, as markets digest the fiscal implications of the Trump administration’s latest budget and prepare for expected interest rate cuts by the Federal Reserve. According to Lombard Odier’s latest CIO Office Viewpoint, the budget deal expands the US deficit by US$4 trillion over a decade, with minimal benefit to growth, exacerbating long-term fiscal risks and weighing on the greenback.
"A worsening of an economy's fiscal outlook, generally accompanied by an increase in government borrowing or spending, pften results in investors requiring a higher premium to hold longer-term debt," says Dr Luca Bindelli, head of investment strategy at Lombard Odier. "Indeed, we can think of interest rates as reflecting the expectation of evolving short-term rates, plus a premium that compensates investors for holding longer maturities."
While the US job market remains resilient, Lombard Odier expects rising unemployment by end-2025, a consequence of hiring freezes and slowing consumption. Against this backdrop, the Fed is forecast to lower interest rates three times this year, shifting from a restrictive to a neutral policy stance. This shift should gradually push 10-year Treasury yields lower over the next 12 months, reversing the recent rebound above 4.3%.
The term premium on US Treasuries or compensation for holding longer maturities, has turned positive for the first time in a decade. Yet, it remains modest by historical standards.
"More importantly however, term premia are heavily influenced by cyclical factors. They tend to be highest just before recessions, when investors expect steep cuts to interest rates. We do not expect a recession in the US, but slower growth, and therefore a moderately high US term-premium ahead," says Bindelli.
This mix of lower expected policy rates and higher term premiums has historically coincided with phases of USD depreciation. The current setup resembles that trend: fiscal expansion, declining yield advantage, and anticipated Fed easing are all converging to undermine the dollar. The DXY index may remain volatile, but is likely to trend lower in the near term. The EUR/USD is expected to hover around 1.15–1.20, with fair value estimated in that band.
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Foreign investors remain cautious about US Treasuries, primarily due to unattractive returns when hedged back into local currencies. For euro-based investors, for instance, the high cost of hedging US bonds makes German Bunds a more appealing option, despite lower nominal yields. This relative unattractiveness could limit foreign demand for Treasuries until hedging costs decline.
However, US domestic investors still hold around two-thirds of the Treasury market, providing a base level of demand. Washington is also advancing two initiatives to improve market liquidity. Regulatory adjustments to bank capital rules could boost balance sheet capacity for Treasuries. In parallel, the Genius Act — designed to foster stablecoin issuance backed by US Treasury assets — may create an additional channel for liquidity and demand.
Despite headline concerns, Lombard Odier does not see the growing US deficit as an immediate threat to equity markets unless it reignites inflation and restricts the Fed’s ability to ease. Their base case sees inflation moderating to 2.8% in 2025 and 2.7% in 2026, allowing the Fed to proceed with cuts.
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A weaker dollar is a net positive for global financial conditions. It eases funding costs, supports multinational corporate earnings, and boosts emerging market (EM) risk assets. Indeed, EM currencies have already gained from the improved risk environment, as global capital seeks higher-yielding opportunities amid falling US yields.
This capital rotation underscores the reassessment of relative value, as investors look past the US towards markets offering yield without the fiscal baggage. According to Lombard Odier, the US’s evolving policy mix that involves looser monetary conditions coupled with expansive fiscal policy, is likely to maintain pressure on the dollar, even if some legislative elements temper the initial impact. Notably, the recent budget retains tax credits from the 2022 Inflation Reduction Act for another year, which may spur cyclical investment.
Looking ahead, the interplay between US fiscal dynamics, monetary policy, and inflation will be central. Any renewed inflationary pressure could derail the Fed’s rate-cutting path and tighten global financial conditions. For now, however, the current environment of dollar weakness, rate cut expectations, and moderate inflation provides a constructive backdrop for risk assets.
Still, volatility is expected. As term premiums rise and the Fed pivots, the Treasury market’s sensitivity to policy shifts remains high. Investors will be closely watching indicators such as unemployment trends, inflation prints, and Treasury auctions for signs of stress or resilience.
In sum, the US dollar’s oversold state may invite brief rebounds, but fundamental drivers continue to point towards sustained weakness. That, in turn, helps support global liquidity, a rare case where poor fiscal optics may yield broader market benefits.
