Fed rate pause bets drag United States Dollar Index down towards 101.50

The US Dollar Index retreats as weaker September housing starts and record-low pending home sales underscore fragility in the US economy.
Inflation and rate-hike expectations could strengthen as drone strikes in the Middle East and the Russia-Ukraine conflict send oil prices sharply higher.
Investors are reassessing the "higher-for-longer" rate narrative as expectations at the long end move lower, according to ING.

Subdued trading continues for a third consecutive day in the US Dollar Index (DXY), which hovers near 101.50 during Thursday’s European session. The index tracks the US Dollar (USD) against six major currencies.

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Pressure on the Greenback reflects signs of US economic weakness in the latest releases: housing starts declined in September, while pending home sales dropped to a record low. The CME FedWatch Tool puts the probability of the Fed leaving interest rates unchanged next week at 84%, with traders also assigning a 90% chance to a December rate hike. The outlook nevertheless remains uncertain, as Fed Chair Kevin Warsh declined last week to indicate when further interest rate increases might be needed, or whether they would be necessary.

Rising oil prices could, however, lend support to the US Dollar by stoking inflation concerns and strengthening expectations of a Federal Reserve (Fed) rate hike. Crude gained after a drone strike on Saudi Aramco’s Shaybah oil field caused two casualties. The attack heightened tensions in the Middle East and concerns about possible disruptions to energy supplies. 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 increase in diesel exports under a recent agreement between Presidents Trump and Putin.

Is long-end repricing challenging the ‘higher for longer’ rate outlook?

A “subtle change in the rate markets” is taking place, according to ING analysts. During late summer, especially September, they say rising energy prices were closely linked to a “'higher rates forever'” narrative. That association drove the one-month USD OIS priced 10 years forward to “5.17% – miles away from any neutral rate near 3.50%.” With ING now describing those views as “changing,” the latest repricing at the long end suggests investors are beginning to doubt how sustainable the earlier higher-for-longer position is.

US Dollar: frequently asked questions

What role does the US Dollar play?

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

How does Federal Reserve policy affect the US Dollar?

Monetary policy, set by the Federal Reserve (Fed), is the single most significant influence on the US Dollar’s value. Achieving price stability by controlling inflation and promoting full employment are the Fed’s two mandates. Interest rate adjustments are its main means of pursuing these objectives. The Fed will increase rates when prices climb too rapidly and inflation exceeds its 2% target, 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?

The Federal Reserve may respond to extreme circumstances by printing additional Dollars and introducing quantitative easing (QE). Through QE, the Fed sharply expands the supply of credit to a financial system that has become stuck. This unconventional policy is deployed when credit dries up because banks refuse to lend to one another for fear of counterparty default. It serves as a last resort if interest rate cuts alone are unlikely to deliver the required outcome. During the Great Financial Crisis in 2008, the Fed chose this approach to tackle the credit crunch. Under QE, newly printed Dollars are used by the Fed to purchase US government bonds, mainly from financial institutions. The US Dollar typically weakens as a result.

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

The reverse of quantitative easing is quantitative tightening (QT). Under QT, the Federal Reserve halts bond purchases from financial institutions and, as bonds in its portfolio mature, does not reinvest the principal in fresh purchases. This process generally supports the US Dollar.