Oil-driven inflation and Fed neutrality keep United States Dollar Index firm

Higher oil prices lift global inflation risks, supporting gains in the US Dollar Index.
83.9% is the market-implied probability of a rate hold next week, according to the FedWatch Tool.
Ahead of October’s policy meeting, Fed Chair Warsh declines to prejudge decisions and gives no clear guidance.

101.80 is the level around which the US Dollar Index (DXY) is trading in Wednesday’s Asian session. After modest gains the previous day, the index is edging higher. It tracks the US Dollar (USD) against six major currencies. Rising oil prices are fuelling global inflation concerns and demand for safe-haven assets, helping the Greenback retain its recent gains.

TMGM Analysis: Financial Market News, Economic Calendar & Market Insights

Mixed signals on diplomatic contacts between the United States (US) and Iran kept traders cautious as crude prices rose. Talks remain active, but high-level meetings in Tehran weighed on market sentiment. Pakistan’s army chief, Field Marshal Asim Munir, met senior Iranian diplomatic and military leaders there to discuss bilateral relations and the progress of talks with Washington. A diplomat participating in the discussions said efforts to resolve the conflict were continuing, but reports that a final agreement was imminent were premature.

An 83.9% probability of unchanged interest rates next week is currently priced in by traders, according to the CME FedWatch Tool. Markets also assign a 90% probability to a December rate increase as they assess the Federal Reserve’s (Fed) next steps. Fed Chair Kevin Warsh, however, remained neutral. He stressed that he does not "prejudge" interest rate decisions, giving markets no firm indication of whether the central bank will increase rates or leave them unchanged at the forthcoming October policy meeting.

USD faces further risk from tech sell-off

Currency markets could become increasingly exposed to equity market developments, Scotiabank strategists warn. They argue that “a deeper shakeout in tech stocks could become a further headwind for the USD, given the dominance of the AI build-out in the US growth/inflation narrative.” Sustained weakness across the technology sector would, in their assessment, threaten one of the main themes underpinning the Dollar. That would reinforce the prevailing broad USD weakness as markets reconsider the risk of near-term Fed tightening.

US Dollar: key questions

US Dollar: role and global use

More than 88% of global foreign exchange turnover involves the US Dollar (USD), the world’s most actively traded currency. Data from 2022 puts its average daily transaction volume at $6.6 trillion. The USD is the official currency of the United States of America. It also serves as the ‘de facto’ currency in a substantial number of other countries, circulating alongside their local banknotes. 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 Gold Standard ended with the Bretton Woods Agreement in 1971.

Federal Reserve policy: the US Dollar link

Monetary policy set by the Federal Reserve (Fed) is the single largest influence on the US Dollar’s value. Adjusting interest rates is the Fed’s main tool for meeting its two mandates: price stability, meaning control of inflation, and full employment. If prices climb 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 rate cuts, putting pressure on the Greenback.

Quantitative Easing: implications for the US Dollar

Faced with extreme conditions, the Federal Reserve can print additional Dollars and introduce quantitative easing (QE). This process sharply expands the flow of credit through a financial system that has stalled. QE is an unconventional policy response to a credit shortage caused by banks refusing to lend to one another for fear of counterparty default. It is 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 entails printing more Dollars and using them to purchase US government bonds, mainly from financial institutions. The US Dollar typically weakens as a result of QE.

Quantitative Tightening: implications for the US Dollar

Usually supportive of the US Dollar, quantitative tightening (QT) reverses the process. The Federal Reserve ceases bond purchases from financial institutions and, as its existing bonds mature, does not reinvest the repaid principal in new purchases.