Why a Weaker Dollar May Boost International Bonds

Looking ahead, we expect the dollar to gradually weaken, but that's only part of the total-return puzzle. Income payments and potential price changes matter, as well, as the chart above highlights. The price return of the Bloomberg Global Aggregate ex-USD Index is negative so far this year compared to a positive price return for the Bloomberg US Aggregate Index, and its income return was a bit lower, as well.

Below we'll cover those key drivers of global bond total returns—currency, price, and income—and what investors should know now.

The outlook for a weaker dollar is important for the global bond outlook because currency movements tend to have an outsized effect on global bond investment performance, as the chart below highlights.

Compare that to the coupon returns, which are always positive albeit low, and price returns. Price returns can be a bit volatile as well, but the fluctuations tend to be smaller than the fluctuations with currency returns. Large moves in currencies—up or down—tend to matter more for global bond performance than the potential income and price returns.

We expect the dollar weakness to continue, with the Federal Reserve expected to begin cutting rates again later this fall. Interest rate differentials tend to be a key driver of currency values because capital tends to flow to areas with higher yields, so the dollar could decline if the yield advantage that U.S. bond investments currently offer above international bond investments declines.

Trade policy concerns could weigh on the dollar as well. If U.S. economic growth continues to moderate, investors may begin to look elsewhere for higher returns. If the ultimate goal of tariffs is to reduce trade deficits, that could weaken demand for the dollar, as well. While we have trade deficits with many countries, the U.S. dollars received for foreign goods are often returned back into the U.S. through stock and bond purchases, resulting in a capital account surplus. That dollar demand could weaken if trade deficits do in fact decline.

Despite the more than nearly 9% decline from the January 2025 high, the Bloomberg Dollar Spot Index is still near the middle of the range it has held since late 2014. An additional drop to the 1100 level, the bottom of that recent range, would represent an 8% decline.

This relationship is nothing new. The Bloomberg US Aggregate Index has offered a higher average yield than the Bloomberg Global Aggregate ex-USD Index for years.

The roughly 180-basis-point (1.8%) advantage that the US Agg offers is at the high end of its 15-year range but is below the recent highs of roughly 240 basis points that it has offered a few times over the past few years. Investors looking for higher income payments are already generally starting with a disadvantage when considering international bonds, and over time would likely need some currency appreciation to help close that gap.

Central bank policies can play a large role in the overall direction of government bond yields. They tend to have a more direct impact on short-term yields—think maturities of two or three years or less—and an indirect impact on long-term yields, like a 10-year government bond yield. Bond prices and yields generally move in opposite directions in the secondary market, so falling yields usually result in rising bond prices and higher total returns.

The Federal Reserve is expected to resume cutting rates later this year and into next year. The federal funds futures market is implying a fed funds rate of roughly 3% by the end of 2026, suggesting short-term rates could fall by a magnitude of 125 to 150 basis points over the next 15 months. Other central banks appear to be ending their rate-cut campaigns, however.

The European Central Bank (ECB) has cut its benchmark policy rate by a total of 200 basis points, or 2%, since it first cut rates in June 2024. While the Federal Reserve has held its rate steady since its cut last December, the ECB continued to gradually lower rates through this past June. With a policy rate near 2%, market expectations suggest the ECB may be done cutting rates for this cycle, although incoming data could change that outlook, of course. Meanwhile, the Bank of Japan, not shown in the chart below, has been gradually hiking rates after holding rates in negative territory since 2016.

Taken together, European and Japanese bond yields might not move much lower, and could end up moving higher, while U.S. yields should be biased lower. U.S. bonds appear to have more price upside over the short run based on that outlook. However, the magnitude of the potential price appreciation might not be enough to offset the impact of our outlook for a modestly weaker dollar.

The global bond market is large, with the governments of many countries issuing bonds in different currencies. Policies by certain central banks, and the direction of certain currencies, can have a larger impact on most global bond investments than others. The euro makes up 42% of the Bloomberg Global Aggregate ex-USD Index, with the Chinese renminbi and Japanese yen making up 18% and 16%, respectively. Movements by bonds issued in these currencies likely will have an outsized impact on a strategy that tracks a developed-market bond index.

The outlook for international bonds investments is more attractive than it has been in a while, given our outlook for a weaker dollar. Although investors historically have received lower yields and income payments, when considering international developed market bond investments, the potential for local currencies to rise in the short to medium term suggests that the outperformance should continue.