US Dollar supported by Fed policy outlook and geopolitical tensions, experts agree

0.6% in three days: US Dollar Index climbs above 102.00 to fresh two-week highs.
Ahead of Wednesday’s expected hawkish hold by the Fed, investors are moving back into the US Dollar.
Fading prospects of an imminent US-Iran peace deal add to safe-haven support for the USD.

More than 0.6% has been added to the US Dollar Index (DXY) over the last three trading days. The index, which tracks the US Dollar (USD) against a basket of six peers, has reached two-week highs above 102.00. The US Dollar ranks among the strongest major currencies over recent sessions as investors await next Wednesday’s Federal Open Market Committee (FOMC) meeting outcome.

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Expectations of a hawkish hold by the Federal Reserve (Fed) have prompted traders to take long positions in the US Dollar this week. Markets anticipate that the decision will confirm expectations for a quarter-point rate increase in December. Meanwhile, the latest effort to ease Middle East tensions has produced no result, as with previous attempts. Continuing clashes between regional powers and attacks in the Strait of Hormuz are also supporting demand for the USD as a safe haven.

Fed decision approaches as Dollar support builds

ING’s Chris Turner links the supportive outlook for the dollar to energy prices and geopolitical risks: “energy prices firm and expectations growing that the US and Israel will launch another attack on Iran (...) we expect central banks to stay hawkish. This should keep the dollar supported on dips.”

A similar view comes from analysts at HSBC, who "expect the USD to consolidate near its recent highs over the coming weeks, with risks tilted towards further gains rather than material weakness."

A more neutral USD outlook is nevertheless favoured by HSBC. Its experts argue that "US economic resilience, a hawkish Federal Reserve and potential challenges for other currencies should limit the USD’s downside, without necessarily providing the momentum for another leg higher."

Persistent inflation risks also underpin TD Securities’ forecast for a cautious FOMC stance following Wednesday’s meeting. Its expert sees the same direction of travel: “A hold in October will make a December hike all the more likely,” according to TD Securities.

USD demand rises as Eurozone credit strains deepen

October’s ECB survey points to pressure on Eurozone growth, according to strategists at Brown Brothers Harriman. It “showed a further net tightening of credit standards and weaker loan demand in Q3,” a combination that “is a headwind to Eurozone economic activity and challenges the nearly 75bps of ECB hikes priced by markets over the next twelve months.”

Turning to the US outlook, BBH says “September durable goods orders and ADP weekly employment change will likely underscore the resilience of the economy,” while “rising gasoline prices point to worsening near-term inflation expectations in October’s consumer confidence survey.” Taken together, these factors strengthen the case for the Fed to maintain a firm monetary policy stance.

US Dollar: Key Questions

What role does the US Dollar play?

Over 88% of global foreign exchange turnover involves the US Dollar (USD). According to data from 2022, this represents average daily transactions of $6.6 trillion, making it the world’s most heavily traded currency. The USD is the official currency of the United States of America. In a significant number of other countries, it also circulates alongside local banknotes as the ‘de facto’ currency. 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 brought an end to the Gold Standard.

How does Federal Reserve policy affect the US Dollar?

Monetary policy is the single biggest influence on the US Dollar’s value. The Federal Reserve (Fed) sets that policy under a dual mandate: maintaining price stability by controlling inflation and promoting full employment. Interest rate adjustments are its main tool for meeting both objectives. Inflation above the Fed’s 2% target, with prices climbing too rapidly, prompts rate increases that support the USD. Conversely, inflation below 2% or an excessively high Unemployment Rate may lead 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?

In extreme circumstances, the Federal Reserve can print additional Dollars to implement quantitative easing (QE). This substantially expands the flow of credit through a financial system that has become blocked. As an unconventional policy tool, QE addresses a shortage of credit when banks refuse 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. Under this process, newly printed Dollars are used to purchase US government bonds, mainly from financial institutions. The US Dollar typically weakens as a result of QE.

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

Usually supportive of the US Dollar, quantitative tightening (QT) reverses the process of QE. The Federal Reserve stops purchasing bonds from financial institutions. It also refrains from reinvesting the principal repaid when bonds in its portfolio mature into new bond purchases.