A Comprehensive Analysis of the Dollar's Valuation Logic: A New Framework Beyond Interest Rate Spreads

Logic: The more negative the Basis (the deeper it falls), the more intense the market demand for the US dollar, or the extremely high cost of hedging the risk of the US dollar.

Shadow Signal: If the Basis continues to hover in the extremely negative range, it means that even if foreign investors want to hedge, the cost may deter them. If the US dollar still does not rise at this time, it means that foreign investors have simply reduced their allocation to US Treasury bonds, or are looking for alternative safe assets other than the US dollar.

• Observation Point: The "Hedging Appetite" index of institutional investors.

• Shadow Signal: These banks directly control trillions of dollars in cross-border settlements. If the report shows that the hedging ratio of "Real Money" (referring to long-term funds such as pension funds and sovereign wealth funds) is at a historical high, then even if the US Treasury yield spread is high, the spot exchange rate of the US dollar will hardly have explosive power.

3. Yield Composition Affects the Direction of the US Dollar

Another important reason why the yield spread logic sometimes fails is the structural change of US Treasury yields.

Thinking deeply about the linkage logic between US Treasury yields and the US dollar exchange rate, we can find that the causes of yields determine the direction of the US dollar. First, when rising yields are driven by expectations of short-term interest rates, this is usually a signal of strong fundamentals. It represents stronger-than-expected US economic growth, resilient inflation, or a hawkish stance from the Federal Reserve to curb overheating. In this case, capital flows into the US in pursuit of higher and safer certain returns, creating strong upward momentum for the dollar. However, when rising yields stem from a rise in term premiums, their nature shifts from a growth dividend to risk compensation. This reflects market concerns about runaway fiscal deficits, increased policy volatility, or geopolitical uncertainty. At this point, investors are not buying because they are optimistic about the US economy, but because they are demanding a higher premium out of fear of future risks. This questioning of sovereign credit and policy stability essentially erodes the value of the currency, and therefore not only fails to support the exchange rate but often balances this risk cost by weakening the dollar. Therefore, we can conclude that: If the rise in US Treasury yields stems from expectations of short-term interest rates, it is generally bullish for the US dollar. If it stems from term premiums, it reflects market concerns about fiscal or policy risks, which is often bearish for the US dollar. 4. The global macroeconomic background leads to a passive strengthening of the US dollar. This is relatively easy to understand. We all know the composition of the US dollar index, so political or fiscal disturbances in non-US economies (such as Europe) will cause the US dollar to passively strengthen as a relative price. In the game of macro-financial dynamics, exchange rates are essentially a game of comparison. The strength of the US dollar is often not entirely due to the outstanding performance of the US economy, but rather reflects a relative premium for hedging against risk. When non-US economies such as Europe experience political turmoil (e.g., election stalemates, geopolitical conflicts) or fiscal imbalances (e.g., debt pressure, budget overruns), market expectations for the region's currencies deteriorate rapidly. Since the foreign exchange market reflects the relative prices between currencies, when major currencies like the euro and pound sterling experience recession fears or liquidity contractions due to internal disturbances, global capital instinctively flows to the most liquid and safest dollar assets for safety. This "passive strengthening" reveals a harsh logic: even if the US's own fundamentals are weak, as long as other major economies perform worse, the dollar automatically gains appreciation momentum due to its relative weight. In this situation, the dollar is less sought after because of improved economic conditions and more passively valued as the ultimate antidote to the global financial system. 5. Sentiment Factor – “De-dollarization” As mentioned above, the stronger the call for “de-dollarization,” the lower the convenience benefits. “De-dollarization” is not necessarily a fact; mere sentiment can influence the value of the dollar. As traders (especially those focused on the forex market), it's crucial to understand that “de-dollarization” is a long-term, slow-moving variable. It involves deep shifts at the systemic level, including trade pricing, cross-border payments, and foreign exchange reserve structures. Its verification typically requires years of data observation. Given the highly concentrated supply of safe assets globally, existing funds cannot quickly complete “de-dollarization.” In the global supply of safe assets, US Treasury bonds hold an absolute advantage in size, with a circulating market size of approximately $31.5 trillion. Globally, the pool of alternative assets offering equivalent depth, liquidity, and collateral functionality is significantly smaller. US Treasury bonds are not only investment products but also the underlying architecture of the global financial system, playing a central role in cross-border settlements, large-scale financing hedging, and liquidity management. In contrast, the divergence between the dollar and interest rate differentials that emerged in 2025 was driven more by the short-term, fast-moving variable of "convenience yield." Convenience yield reflects the willingness of marginal funds to pay for the safety attributes of the dollar (such as liquidity and collateral functions) within a specific window of time; this willingness can fluctuate or correct rapidly within a few days. For example, there was a temporary decline in convenience yield in April 2025 and its subsequent return in July. Due to a lack of substitutes, a more feasible approach for the market is not to remove existing assets (i.e., liquidate dollar assets), but rather to change marginal behavior. This predicament can be likened to a giant reservoir: even if the water quality is unsatisfactory (policy uncertainty), because there are no other sufficiently large reservoirs nearby to hold so much water (insufficient depth of alternative assets), you can only stay where you are, but you can reduce risk by installing filters (currency hedging). Therefore, misinterpreting this short-term risk premium reassessment at the trading level as a long-term structural change may lead investors into a one-sided risk in their strategic judgments. —————— In summary, since traditional logic is no longer effective, we need to use new indicators to predict the performance of the US dollar in 2026. Here are three ideas for you: Price Signals: Observe the US Treasury basis or cross-currency basis to see the latest evaluation of investors' dollar convenience benefits. Hedging Costs: Observe changes in the hedging ratio to see if funds are still systematically avoiding dollar risk. Determine if the rise in US Treasury yields is due to economic growth expectations or term premium (risk compensation).