Last Friday was the end of the third quarter, and it marked an important milestone for the dollar. The DXY recorded 11 consecutive weeks of gains, for the strongest quarterly performance of the year. As the premier safe haven currency, the gain in the greenback ahead of a possible US government shutdown was quite expected. But, can it keep going?
The Support Remains
The main reason for the dollar’s gain has been the rising yields, which touched a 16-year high just a week ago. Higher yields make a currency more attractive, and are often driven by monetary policy. The Fed has driven interest rates to highs not seen since the dot-com bubble. But, the expectation is that rates will level off now.
The thing is, most economists were expecting a recession that would force the Fed to cut rates. But now the consensus has swung to the market pricing in the most likely scenario is that the economy will continue to grow. With inflation still above the Fed’s target – and expected to remain there for some time – that means interest rates will remain elevated. Which means that yields just keep drifting higher.
The Spending Factor
With the value of the dollar closely linked to yields, how much spending the government does is very relevant to forex. The Fed is pulling $90B in liquidity out of the market each month through its quantitative tightening program. That is, essentially, selling US government debt.
Meanwhile, the US government needs to keep borrowing to pay for its $1.52T (estimated) deficit. On top of that, the government has to sell more debt to cover bonds and bills that are reaching maturity. It’s expected that the Treasury will have to issue $7.6T in debt over the next year. As long as there is plenty of liquidity, this isn’t a major issue.
Keeping yields elevated
If the Treasury has to issue a lot of debt, it needs to offer the bonds at higher interest rates. That means, as the amount of debt issuance increases, there is upwards pressure on yields. As long as there is no crisis of confidence in the government’s ability to pay, that simply translates into upward pressure for the dollar.
If the economy grows slowly, and government spending increases at a faster rate, then the amount of money the government needs to borrow would increase. The latest resolution to extend the budget did not result in any decrease in spending. Increased borrowing would pressure yields to the upside and support the dollar.
The other scenarios
On the other hand, if the economy were to take off, then the government would collect more in taxes. This would reduce the amount of debt it would need to issue – and people would have more money to buy bonds with. That way, yields would remain low and the dollar could weaken.
The third option is that there is a recession, in which case the Fed has to cut rates. That would reduce yields and weaken the dollar as well. There is a range of slow growth that motivates increased government spending, which could translate into the dollar continuing to gain against other currencies. Particularly if other major economies falter, and their central banks look to ease some of the recent tightening.
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