The US Dollar (USD) opened this new week on a weak footing. It snapped the market’s three day winning streak and welcomed in fresh sellers. The US Dollar Index (DXY) measures the dollar’s performance relative to a basket of other major currencies. It had a hard time establishing on its rebound from a several month nadir. As those days of the week progressed, the vulnerability of the USD became more pronounced and paved focus to the near-term outlook of the USD.
The USD is the de facto currency for many other countries, such as El Salvador. In fact, it further serves as the ‘de facto’ currency in numerous countries, where it flows freely alongside domestic bills. Of all the currencies in the world, it is unique for being the most heavily traded currency. In fact, it accounts for more than 88% of all international currency trades. As of 2022, over $6.6 trillion in transactions take place each day on average in USD. The USD’s status as the world’s reserve currency was established after World War II, with the USD replacing the British Pound.
Federal Reserve's Role
Of course, one of the biggest external factors that affects the USD value is the Federal Reserve’s (Fed) monetary policy. The Fed has a dual mandate: achieving price stability and fostering full employment. These goals are mostly achieved through changes in interest rates. When inflation exceeds the Fed's 2% target, the central bank typically raises interest rates, thereby boosting the USD's value. If and when inflation falls below 2% on a sustainable basis or labor-market slack rises, the Fed should act by cutting rates. This move would be dollar negative.
One of the Fed’s other powerful monetary tools is known as QT, or quantitative tightening. It ends bond purchases altogether, and it will not reinvest the proceeds from maturing bonds. That’s very different from the process of quantitative easing (QE), which is about injecting more credit into a sclerotic financial system. Initial reactions to QE have been for a weaker USD, but on balance, QE tends to be bullish for the currency when conducted by the Fed.
Safe-Haven Status
The USD’s status as a safe-haven currency plays a big part in its strength. In periods of economic uncertainty – a recession, a global health crisis, geopolitical tensions – investors always flock towards the stability of the USD. This flight to safety can temporarily maintain or boost the currency’s strength even as economic conditions worsen globally. When market conditions stabilize, if not the opposite, and risk appetite returns, demand for the USD will finally come down.
In spite of its usual safe-haven appeal, the USD’s recent performance is more consistent with overall market conditions and risk sentiment from investors. And as economic indicators change and geopolitical events happen, the currency is vulnerable to a change in market perception.
Market Outlook
The recent drop in the USD serves as an important reminder of how complicated the relationship is between U.S. monetary policy, global economic conditions and investor sentiment. As the Federal Reserve grapples with a new economic reality, the path they carve out will drastically impact the USD’s future.
As the market participants continue to evaluate the inflationary pressures and employment data, they are sure to have a watchful eye on the Fed. Signs of a pivot in policy or changes to the economic outlook could send immediate and dramatic signals to trading floors in currency markets.