The direction of the U.S. dollar is emerging as the key driver of global capital flows in the second quarter, with currency moves increasingly steering regional and sector allocation, according to Bob Savage, head of markets macro strategy at BNY.
He said the link between the U.S. dollar index and the rest of world (ROW) equity index has been unusually tight over the past year, leaving global portfolios highly sensitive to shifts in the greenback.
u.s. stocks outpace rest of world as divergence widens
Since the start of the current rally, the S&P 500 has climbed 26%, while the top 20 ROW names are up 13%. Both U.S. and international equity benchmarks have largely retraced to pre-conflict levels, tracking the dollar’s recovery.
Savage noted that the performance gap between the S&P 500 and ROW equity indices has become broad and persistent, making momentum-based strategies harder to execute across regions. Moves in the dollar remain a primary force behind cross-border portfolio rebalancing through the quarter.
central bank paths diverge and lift the euro
Policy signals are feeding directly into foreign exchange pricing. Markets currently see two 25-basis-point rate hikes by the European Central Bank in 2026, while assigning only about a 40% chance to a single rate cut by the Federal Reserve over the same horizon.
That divergence has helped push the euro higher, from 1.15 to 1.18 against the dollar within a week. The changing rate outlook on each side of the Atlantic is reshaping expectations for currency trends and relative asset performance.
emerging markets face tighter funding conditions
Emerging markets are contending with tighter front-end yields as authorities weigh the risk of currency instability and potential intervention. Expectations of further official action to support exchange rates are reinforcing higher short-term funding costs in several regions.
The International Monetary Fund recently trimmed its 2026 growth projection for emerging markets to 3.9%, citing vulnerability to energy prices and exchange-rate swings. That weaker outlook comes as non-dollar assets face additional pressure from rising relative returns on safer, dollar-denominated debt.
dollar strength tightens global financial conditions
Savage described the current backdrop as one of cyclical support for the dollar, underpinned by geopolitical flight-to-quality flows and resilient U.S. growth.
A stronger U.S. currency effectively tightens global financial conditions, raising the bar for assets that depend on abundant global liquidity and elevated risk appetite. That can accelerate capital outflows from markets viewed as more speculative or less liquid.
Data from the CME FedWatch tool show the probability of the Fed holding rates steady at its April meeting is above 98%. At the same time, expectations for rate cuts later in the year have been scaled back significantly following persistently firm inflation readings.
This stands in contrast to a European Central Bank that is seen leaning toward further tightening in response to energy-driven price pressures, reinforcing the broader policy divergence.
volatility risk for globally traded, non-sovereign assets
The gap between major central bank paths and the resulting currency moves raise the risk of sharper volatility in assets that trade around the clock, including those closely tied to global liquidity conditions.
Because many of these non-sovereign assets tend to correlate with emerging market currencies, sudden depreciations or capital pullbacks in those economies could serve as early warning signals of wider market stress.
corporate outlook hinges on margins and supply chains
On the corporate side, performance in the coming quarter is expected to depend heavily on how effectively companies manage margins and navigate ongoing supply disruptions.
Earnings for S&P 500 companies are forecast to post strong growth this year, helped in part by a large capital expenditure cycle in the technology sector. However, outside the biggest tech names, rising input costs and persistent bottlenecks—compounded by geopolitical tensions—are prompting many firms to moderate profit expectations for the next few quarters.
Comments from corporate executives on earnings calls will be watched closely for signs of demand resilience and cost pressures through mid-year, offering clues on whether the broader economic backdrop remains supportive or begins to soften under the weight of tighter financial conditions and a stronger dollar.
As dollar strength reshapes global liquidity, learn how traditional and decentralized finance intersect in our guide to TradFi vs DeFi.
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