Near 101.50: United States Dollar Index slips on Fed rate pause bets

September housing starts fell and pending home sales reached record lows. These signs of US economic weakness weighed on the US Dollar Index.
Drone strikes in the Middle East and the Russia-Ukraine conflict have sent oil prices higher, potentially lifting inflation and expectations of rate increases.
As long-end market expectations move lower, investors are challenging the "higher-for-longer" rate narrative, according to ING.

101.50 is the level around which the US Dollar Index (DXY) is trading during Thursday’s European session. The index, which tracks the US Dollar (USD) against six major currencies, remains subdued for a third consecutive day.

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Signs of US economic weakness continue to challenge the Greenback. Recent releases showed a fall in September housing starts and a record low in pending home sales. The CME FedWatch Tool puts the probability of the Fed leaving interest rates unchanged next week at 84%, while traders assign a 90% chance to a December rate hike. The outlook remains uncertain, however. Last week, Fed Chair Kevin Warsh offered no guidance on whether further interest rate increases would be needed or when they might occur.

Rising oil prices could nevertheless support the US Dollar by stoking inflation concerns and strengthening expectations of a Federal Reserve (Fed) rate hike. Crude advanced after a drone strike on Saudi Aramco’s Shaybah oil field caused two casualties. The attack heightened Middle East geopolitical tensions and concerns about possible energy supply disruptions. Meanwhile, Ukraine launched large-scale drone attacks on key Russian oil infrastructure this week. The strikes signalled Kyiv’s intention to obstruct Moscow’s planned expansion of diesel exports under a recent agreement between Presidents Trump and Putin.

Long-end repricing challenges ‘higher for longer’ rate outlook

A “subtle change in the rate markets” is taking place, according to analysts at ING. In late summer, especially September, they say rising energy prices were closely linked to a “'higher rates forever'” narrative. That pushed the one-month USD OIS priced 10 years forward to “5.17% – miles away from any neutral rate near 3.50%.” Those views are now “changing,” ING says. Recent long-end repricing suggests investors have begun to question how durable the earlier higher-for-longer position will prove.

US Dollar: Key questions

What role does the US Dollar play?

The United States of America uses the US Dollar (USD) as its official currency. In a significant number of other countries, it also circulates alongside local banknotes as the ‘de facto’ currency. No other currency is traded more heavily: according to 2022 data, the USD accounts for over 88% of global foreign exchange turnover, equivalent to an average of $6.6 trillion in daily transactions. After the Second World War, the USD replaced the British Pound as the world’s reserve currency. Gold backed the US Dollar for most of its history, until the Bretton Woods Agreement in 1971 marked the end of the Gold Standard.

How does Federal Reserve policy affect the US Dollar?

Monetary policy set by the Federal Reserve (Fed) is the single most important influence on the US Dollar’s value. The Fed’s dual mandate is to maintain price stability by controlling inflation and to promote full employment. Adjusting interest rates is its main means of pursuing these goals. If prices rise too rapidly and inflation exceeds the Fed’s 2% target, the central bank raises rates, supporting the USD. Conversely, inflation below 2% or an excessively high Unemployment Rate may prompt the Fed to cut interest rates, putting pressure on the Greenback.

How does Quantitative Easing work, and what does it mean for the US Dollar?

Under extreme conditions, the Federal Reserve can create more Dollars through quantitative easing (QE). This process substantially expands the flow of credit through a stalled financial system. QE is an unconventional policy response to a credit drought caused by banks refusing to lend to one another for fear of counterparty default. It serves as a last resort when interest rate cuts alone are unlikely to deliver the required outcome. During the Great Financial Crisis in 2008, the Fed chose QE to tackle the credit crunch. The process involves creating more Dollars to purchase US government bonds, mainly from financial institutions. A weaker US Dollar is the usual result.

How does Quantitative Tightening work, and what does it mean for the US Dollar?

The opposite process is quantitative tightening (QT). Under QT, the Federal Reserve halts bond purchases from financial institutions and refrains from reinvesting the principal repaid on maturing bond holdings in further purchases. This usually supports the US Dollar.