Experts agree: The fundamental background hints at further US Dollar appreciation

The US Dollar is trimming some gains but most bank analysts expect the broader bullish trend to extend into the coming months.
High US Treasury yields, strong US data, and monetary tightening by the Fed are seen underpinning demand for the USD.
The US Central bank is expected to hike interest rates between three and four times in the next 12 months.

The US Dollar (USD) is showing a moderately softer tone on Wednesday, weighed down by the recent pullback in US Treasury yields and some dovish comments from New York Fed President John Williams. The Dollar Index (DXY), which measures the value of the Greenback against a basket of currencies, has pulled back to 101.20 from two-month highs above 101.60 on Tuesday, but it remains on track for a 1.8% monthly gain.

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Analysts at some of the world's major banks see high US Treasury yields, rising Oil prices stemming from the Middle East war that are boosting global inflation, and the reaffirmation of the Federal Reserve's (Fed) commitment to fight inflation as the main reasons behind the US Dollar's uptrend. Against this backdrop, most of them expect the US Dollar to rise further towards the year-end.

Dollar strength persists as Fed path, yields and oil keep upside risks in focus

Analysts at ING highlight that the US Dollar appreciated further on Tuesday as rising back-end yields continue to weigh on global risk sentiment, which leaves “low-liquidity, higher-beta currencies bearing most of the brunt.” They note that the Japanese Yen remains “the sole exception to the broader Dollar strength trend.”

“Some stabilisation in risk sentiment could take some shine off the Dollar rally,” says ING in a note but warns that with “room for markets to reprice a higher probability of an October Fed hike, it may be premature to call the top in this Dollar move,” suggesting that any near-term pause in the currency’s advance is unlikely to mark a definitive peak.

The Fed is expected to hike rates several times in the next 12 months

OCBC analysts point out that the recent decline in jobless claims highlights a firm labour market and “the risk of an upside payrolls surprise appears to be increasing.” OCBC adds that “a stronger-than-expected employment report would likely reinforce expectations of further Fed tightening, keep Treasury yields elevated and provide additional support for the USD.” All this considered, OCBC’s base case is “for a moderate USD rally into year-end,” but they caution that “markets are currently pricing almost four Fed rate hikes over the next year, which appears overly aggressive.”

In the same vein, Rabobank notes that “USD net longs are largely unchanged as both long and short positions increased by 2,000 positions, respectively,” while the “OIS curve suggests investors are still positioned for more than three hikes by the end of next year.” Taken together, the combination of firm US data, elevated yields, and lingering upside risks around oil leaves the Dollar well-supported, with only the Yen standing out as a notable exception to the “broader Dollar strength trend.”

Analysts at MUFG/BTMU highlight that the US rate market now expects the Fed to deliver "almost another 100bps of rate hikes in the year ahead," a shift that is "reinforcing support for the US Dollar from the positive terms of trade shock for the US economy from higher energy prices." They note that the combination of a more aggressive Fed tightening path and elevated energy costs is underpinning the Dollar’s appeal relative to its major peers.

Fed FAQs

What does the Federal Reserve do, how does it impact the US Dollar?

Monetary policy in the US is shaped by the Federal Reserve (Fed). The Fed has two mandates: to achieve price stability and foster full employment. Its primary tool to achieve these goals is by adjusting interest rates. When prices are rising too quickly and inflation is above the Fed’s 2% target, it raises interest rates, increasing borrowing costs throughout the economy. This results in a stronger US Dollar (USD) as it makes the US a more attractive place for international investors to park their money. When inflation falls below 2% or the Unemployment Rate is too high, the Fed may lower interest rates to encourage borrowing, which weighs on the Greenback.

How often does the Fed hold monetary policy meetings?

The Federal Reserve (Fed) holds eight policy meetings a year, where the Federal Open Market Committee (FOMC) assesses economic conditions and makes monetary policy decisions. The FOMC is attended by twelve Fed officials – the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four of the remaining eleven regional Reserve Bank presidents, who serve one-year terms on a rotating basis.

What is Quantitative Easing (QE) and how does it impact USD?

In extreme situations, the Federal Reserve may resort to a policy named Quantitative Easing (QE). QE is the process by which the Fed substantially increases the flow of credit in a stuck financial system. It is a non-standard policy measure used during crises or when inflation is extremely low. It was the Fed’s weapon of choice during the Great Financial Crisis in 2008. It involves the Fed printing more Dollars and using them to buy high grade bonds from financial institutions. QE usually weakens the US Dollar.

What is Quantitative Tightening (QT) and how does it impact the US Dollar?

Quantitative tightening (QT) is the reverse process of QE, whereby the Federal Reserve stops buying bonds from financial institutions and does not reinvest the principal from the bonds it holds maturing, to purchase new bonds. It is usually positive for the value of the US Dollar.

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