Now that the Fed’s easing cycle will most likely begin in September with rate cuts clearly signalled, it’s worth asking whether we should expect the US Dollar strength to tip over. Over the last couple of weeks, the US Dollar Index has been under pressure, given that the market has been pricing in economic weakness and a rate cut from the Fed. Indeed, it has just hit the year’s low in anticipation of rate cuts to come.
At the same time, the US 10Y Treasury yield has been declining due to fears of economic weakness and declining inflation. Ten-year yields have fallen from 4.7% at the end of April to 3.8% in the past few days. Of course, while inflation may trend lower, the anticipated economic “weakness” might turn out not to be so weak after all. This scenario could lead to a rise in longer-end yields, while the shorter-end continues to price in Fed rate cuts; long bonds might be overbought at these levels.
Rate Differentials with Other Major Currencies
When considering the USD Index, it makes sense to look at the most prominent currency pairs, namely the EUR, GBP, CAD, CHF, JPY and AUD. If the respective central banks of these countries cut more than the Fed and faster, their currencies should weaken against the USD.
- The European Central Bank (ECB) is expected to cut rates again in September and may do so again in November or December due to economic weakness.
- In the UK, the situation is slightly different, with the economy remaining relatively stable and growing, though one more rate cut is still expected.
- The Bank of Canada has already cut rates twice and might consider one more cut this year.
- The Swiss National Bank has also begun easing, surprising the market with two cuts already and possibly cutting again in September.
- The only two currencies showing strength are the JPY and the AUD. The RBA still views inflation as a serious threat.
Geopolitical Risks
Geopolitical risks may continue to keep the USD elevated. Conflicts in the Middle East and Europe are escalating rather than subsiding. The US Dollar remains a safe haven, second only to gold. Additionally, these conflicts are causing oil prices to rise. Since oil is priced in USD, this increases the demand for US dollars.
Economic Policy
The outcome of the upcoming US elections remains poised on a knife edge. However, it is clear that regardless of the candidates’ promises to lower inflation, many of their policies are inflationary. This could lead to a slower Fed cutting cycle and a stronger US Dollar. While candidates may prefer a weaker dollar, adding continued fiscal spending could result in a resurgence of inflation.
This brings us to the relationship between a weaker US dollar and inflation. A weaker currency tends to encourage inflation, so the Fed is likely to be cautious about the pace of rate cuts to prevent a significant weakening of the dollar. This cautious approach will only hold if the economy does not enter a recession.
Currency predictions are notoriously unreliable: so many factors influence movements, and not least momentum and sentiment. The USD has enjoyed a long period of strength, and a reversion to the mean is likely … but precisely when that occurs is anyone’s guess.
US Dollar hits Year’s Low
Source: FT
