The Dollar’s Volatile Path Amidst Economic and Geopolitical Challenges
In the world of finance, September’s US CPI report was the turning point for the dollar’s correction, as anticipated.
Elevated inflation in the United States failed to ignite risk appetite, despite the S&P 500’s initial resilience to higher CPI readings and yields. However, the decline in risk sentiment became apparent after a less-than-enthusiastic UST bond auction, which acted as a catalyst for a sustained sell-off. The S&P 500, after hitting a high near the close of the London trading day, witnessed a 1.4% plunge to an intraday low roughly two hours later, eventually closing by 0.6%.
The 30-year UST bond auction conducted the prior day yielded 4.837%, almost 4 basis points higher than the pre-auction rate, despite being the highest since 2007. A similar trend was observed in the 3-year auction on Tuesday, where the yield reached 4.74%, the highest since February 2007. However, it tailed by nearly 2 basis points, accompanied by a bid-to-cover ratio of 2.56, the lowest since February. The 10-year auction also experienced a tail of nearly 2 basis points, although it boasted a better bid-to-cover ratio of 2.50, surpassing the six-month average of 2.44. The ongoing challenges in the US Treasury market are primarily driven by the unprecedented fiscal outlook in the United States.
A cause for concern is the current state of the fiscal deficit, as the US fiscal deficit has surged by a substantial 60% to reach USD 1.52 trillion in the first eleven months of the fiscal year. This surge in deficit is unparalleled in a year marked by over 2.0% economic expansion, largely attributed to the Tax Cuts & Jobs Act introduced during the Trump administration. The Act, which included significant tax cuts, has eroded the government’s capacity to generate tax revenues, such as capital gains tax.
The IMF’s Fiscal Monitor, released this month, estimates the US fiscal deficit for the year at 8.2%. Over the next five years leading up to 2028, it is projected to average a still significant 7.1%. This unsustainable fiscal outlook underscores the risk of higher yields in the US, potentially creating increasingly unfavourable financial market conditions, ultimately supporting the US dollar. While the correlation between the Dollar Index (DXY) and the S&P 500 has been weakening, it remains negative, reflecting the recent equities rebound. However, the sustainability of this rebound remains uncertain, as exemplified by the mid-cap-focused Russell 2000, which fell by 2.2% the previous day and is now down by 13.5%, nearing recent lows. Further equity selling could intensify and lend support to the US dollar.
Despite the bearish sentiment triggered by rising inflation, the markets remain cautious about pricing in additional Federal Reserve rate hikes. The implied effective Fed Funds rate for December in the futures market has changed only slightly, going from 5.40% to 5.42%, as the narrative pushed by Fed officials suggests that “higher market yields will do the tightening.”
Geopolitical tensions in the Middle East, including the Israeli government’s warnings to evacuate Gaza and reports of Israeli airstrikes in Syria, seem to have played a secondary role in recent global foreign exchange developments. The ongoing volatility in this region makes it difficult to predict market impact. However, the initiation of an Israeli ground offensive in Gaza may encourage more defensive trading, favouring currencies like the dollar, Swiss franc, and yen. Commodity markets have been relatively unaffected so far, but increased oil prices could also benefit the dollar.
The protracted standoff in the US House Speaker bid, where Representative Steve Scalise abandoned his campaign, adds to the risk-off implications. This development could have consequences for domestic fiscal funding and military aid commitments to Israel and Ukraine, which President Biden had promised but may now face approval challenges.
As we head into the weekend, political and geopolitical events are likely to take centre stage in the foreign exchange market. The US calendar for today includes University of Michigan surveys, with a primary focus on inflation expectations gauges, expected to remain stable.
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