The US dollar, a cornerstone of the global financial system, has recently climbed to its highest levels in decades in both nominal effective exchange rate (NEER) and real effective exchange rate (REER) termsFollowing extensive research, Bank of America has asserted that the dollar is significantly overvalued within the G10 currency frameworkAs 2025 unfolds, the dollar's trajectory is expected to follow a “strong early, weak later” pattern, with its specific movements and timing heavily influenced by U.Spolicy developments.

In a report released on January 8, senior analysts at Bank of America traced the origins of this dollar appreciation cycle back to mid-2011. Among the various appreciation phases seen over the past several decades, this cycle has been the longestThe prolonged uptrend reflects deep shifts in the global economic landscape, evolving U.Sdomestic policies, and the intricate interplay of international capital flows

Despite already being at elevated levels, the dollar exhibited further strength last yearA notable event was the Federal Reserve’s aggressive rate cuts in September, followed by robust economic data that reshaped market expectations regarding future Fed policiesThese combined factors drove the dollar higher, with its REER reaching a 55-year high and its NEER hitting its strongest level in 30 years by the end of 2024.

The dollar’s current valuation raises significant questions about its sustainabilityAccording to the International Monetary Fund (IMF), which employs a REER equilibrium model, the dollar is presently overvalued by 18.5%. This level of overvaluation is among the highest in three decades, second only to the 19% peak observed during the 2022 energy crisisFurthermore, Bank of America’s proprietary Behavioral Equilibrium Exchange Rate (BEER) model places the dollar's overvaluation at a staggering 26%, surpassing the 22% recorded in 2022 and marking the highest level in 30 years.

When examined within the G10 currency framework, the dollar’s overvaluation stands out even more prominently

• Japan Mulls Higher Inflation Outlook as Yen Gains
• The Iteration of Large Models May Face a Pause
• Non-Farm Payrolls Surprise with Record Surge!
• Is the Indian Stock Market at its Lowest?
• Rate Cut Halt in January: A Done Deal?

Using various methodologies, including deviations from a 20-year REER average, the IMF’s REER model, and Bank of America’s BEER analysis, the dollar is unequivocally identified as the most overvalued currencyThe Swiss franc trails behind as the second most overvalued, while currencies like the Japanese yen and Nordic currencies, such as the Norwegian krone and the Swedish krona, are among the most undervaluedEven when benchmarked against a 10-year average, the dollar's overvaluation remains the most pronounced.

Looking ahead to 2025, Bank of America predicts a bifurcated trajectory for the dollarIn the near term, the dollar is expected to remain strong, supported by U.Spolicies such as tariffs and inflation management strategiesThese measures could bolster the dollar by reshaping U.Strade dynamics, altering the relative prices of goods, and redirecting global capital flows in favor of the U.S

However, as the year progresses, the negative ramifications of these policies are likely to emergeHigh tariffs may provoke retaliatory measures from trading partners, stifling U.Sexports and constraining growth in domestic industriesSimultaneously, persistent inflation could erode consumer purchasing power, undermining the country’s economic momentum.

Moreover, the evolving responses of other nations to U.Spolicies could exacerbate the dollar’s declineFor example, countries adversely affected by American trade measures might pursue alternative trade alliances or intensify efforts to diversify away from the dollar as the primary reserve currencyThese shifts, coupled with the delayed effects of high tariffs and inflation on the U.Seconomy, could lead to a weakening of the dollar in the latter half of the year.

For investors and market participants, the year ahead demands vigilance