Dollar debasement talk, Japanese Yen carry trade unwinding offset USD safe-haven status
- The US Dollar Index bounces from 98.60 lows but remains capped below 99.00, more than 1% below last week's highs.
- Dollar debasement trade, carry trade unwinding and hopes of global monetary tightening are hurting the USD.
- BBH sees the USD unlikely to rally higher even if US CPI confirms a Fed rate hike next week.
The US Dollar (USD) is failing to capitalise on the risk-averse market this week, as tensions in the Gulf escalate, threatening to widen into a full regional war. The US Dollar Index (DXY) has trimmed some losses but remains relatively close to four-month lows below 99.00 after a nearly 1% decline from last week’s highs. Why did the US Dollar’s safe-haven status stop working?
Investors highlight a combination of reasons behind the recent Greenback's weakness, with USD debasement trade accelerating after the US Treasury announced its plan to buy back long-term securities, but also with other reasons such as the Japanese Yen (JPY) carry trade unwinding dynamics, amid hopes of a steeper Bank of Japan (BoJ) tightening pace, and rising bets of higher interest rates by the rest of the major central banks contributing to it.
Dollar debasement debate weighs on sentiment
Analysts at Rabobank observe that the USD failed to react despite the positive surprise on the Nonfarm Payrolls (NFP) report witnessed last week, boosting hopes of a Federal Reserve (Fed) interest rate hike in September. The “USD’s dithery tone in recent sessions adds weight to the view that there has been a change in sentiment in the FX market," said the Rabobank team in a note.
They argue that the “Dollar debasement debate which was triggered by US Treasury Secretary Bessent’s bond intervention announcement on August 19 appears to have undermined confidence in the greenback,” helping to explain why the currency has struggled to capitalise on otherwise supportive developments.
In the same line, MUFG notes that “the bond buyback expansion was announced on 19th August and since then the dollar index remains around 1% lower despite the short-end of the US yield curve moving to price in more Fed rate hikes.” They see this divergence as evidence that policy developments around the US bond market are weighing on the currency, even as markets factor in a more hawkish Fed path.
ING: Fragile USD/JPY keeps DXY on the back foot
Analysts at ING argue that a “very fragile USD/JPY is probably also contributing to the dollar malaise,” noting that global macro hedge funds are positioning “for a downside break of 150 over the coming months on expectations that Japanese policymakers will deliver on their side of some grand bargain with Washington.”
Against this backdrop, ING concedes that “we don't fully understand why the Dollar is not reacting to higher energy prices” but adds that they “do not see a strong case for DXY to immediately break support at 98.55/65.” However, they caution that “if it were to break, we suspect USD/JPY would be the driver, and a quick drop in DXY to 98.00 could be seen.”
Brown Brothers Harriman’s Elias Haddad sees the US Dollar weighed as markets focus on the upcoming US August Consumer Price Index (CPI) and the Federal Reserve’s (Fed) September 16 monetary Policy meeting. Haddad, however, warns that “even if a September Fed hike becomes a done deal, we doubt USD will make new cyclical highs,” as “tightening by other major central banks limits policy divergence, with the ECB widely expected to deliver a 25bps hike tomorrow,” reducing the scope for further sustained Dollar appreciation.
US Dollar FAQs
The US Dollar (USD) is the official currency of the United States of America, and the ‘de facto’ currency of a significant number of other countries where it is found in circulation alongside local notes. It is the most heavily traded currency in the world, accounting for over 88% of all global foreign exchange turnover, or an average of $6.6 trillion in transactions per day, according to data from 2022. Following the second world war, the USD took over from the British Pound as the world’s reserve currency. For most of its history, the US Dollar was backed by Gold, until the Bretton Woods Agreement in 1971 when the Gold Standard went away.
The most important single factor impacting on the value of the US Dollar is monetary policy, which is shaped by the Federal Reserve (Fed). The Fed has two mandates: to achieve price stability (control inflation) and foster full employment. Its primary tool to achieve these two goals is by adjusting interest rates. When prices are rising too quickly and inflation is above the Fed’s 2% target, the Fed will raise rates, which helps the USD value. When inflation falls below 2% or the Unemployment Rate is too high, the Fed may lower interest rates, which weighs on the Greenback.
In extreme situations, the Federal Reserve can also print more Dollars and enact 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 when credit has dried up because banks will not lend to each other (out of the fear of counterparty default). It is a last resort when simply lowering interest rates is unlikely to achieve the necessary result. It was the Fed’s weapon of choice to combat the credit crunch that occurred during the Great Financial Crisis in 2008. It involves the Fed printing more Dollars and using them to buy US government bonds predominantly from financial institutions. QE usually leads to a weaker US Dollar.
Quantitative tightening (QT) is the reverse process whereby the Federal Reserve stops buying bonds from financial institutions and does not reinvest the principal from the bonds it holds maturing in new purchases. It is usually positive for the US Dollar.