One explanation for the dollar’s weakness is its increased use as a funding currency. The 3-month interest rate differential between the US and a weighted average of its major trading partners has swung from more than 2% a few years ago to below zero today. Exchange rate volatility has also subsided over the past year, thereby lowering the perceived risk of borrowing in lower-yielding currencies to invest in higher-yielding alternatives. (See Chart 1.) While the return of the carry trade could continue to weigh on the dollar for some time, we think its impact will not be that dramatic.
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