USD Weakens Amid Geopolitical Tensions, EURUSD Finds Stability

Since its peak on October 3rd at 107.35, the dollar has shed about 1.6% of its value. Simultaneously, US yields have undergone a correction, dropping from 4.89% to an intraday low of 4.62%, indicating an end to the sell-off in the US bond market that began in early September.

The initial driver for the decrease in US Treasury yields was heightened geopolitical tensions in the Middle East, particularly between Hamas and Israel. These tensions initially led to increased demand for safe-haven assets. However, as concerns of a wider regional conflict eased, investor confidence in riskier assets improved, with MSCI’s ACWI global equity index rebounding by nearly 4.0% over the past five trading days.

Despite this improved risk sentiment, US yields have failed to recover. This suggests that the shift in Federal Reserve (Fed) policy communication toward a more dovish stance is a key factor behind the declining yields and the weakening of the US dollar. In recent weeks, several Fed speakers, including Atlanta Fed President Bostic and San Francisco Fed President Daly, have conveyed a similar message. Bostic stated that there’s no need for further rate hikes and that current policy settings support the 2.0% inflation target.

Daly added that the recent rise in bond yields has tightened financial conditions, potentially reducing the need for more rate hikes, although she noted a slight increase in the neutral policy rate. This still indicates that current policy rates are relatively restrictive.

Despite this week’s correction in US yields, US financial conditions remain tighter than before the summer, providing a reason for the Fed to keep its current interest rates. Market expectations for the November and December Federal Open Market Committee (FOMC) meetings show only a modest increase of around 4 basis points, even after a strong Non-Farm Payrolls (NFP) report for September. This aligns with Fed officials’ guidance that higher bond yields are impacting economic growth and inflation. While the upcoming release of the minutes from the September FOMC meeting might have a slightly more hawkish tone, it’s unlikely to fully reverse the recent dovish recalibration that’s pressuring the US dollar.

EUR:

The EUR/USD exchange rate has found stability around the 1.0600 level, consolidating in the range of 1.06 to 1.063. This stability is primarily due to a dollar correction, with limited bullish support from the euro. The European Central Bank is scheduled to release its August inflation expectations today, and there’s a possibility that the three-year-ahead gauge could see a marginal increase from 2.4% to 2.5%. While not a significant shift, this could provide some modest support to the euro but might not sit well with policymakers.

Two ECB speakers, Elderson and Panetta, will share their views on monetary policy today. Notably, Villeroy has expressed his opposition to raising reserve requirements in a recent speech.

According to a short-term fair value model, there’s potential for the EUR/USD pair to extend its upward correction to 1.0700. However, unless there’s a surprisingly soft reading in the US Consumer Price Index (CPI), I believe the upper limit of the range may be reached in the days ahead, with a return to the 1.0500 level appearing more likely.

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