Next week, there are relatively few of the typically major economic events that could shift the dollar. But, the unusual circumstances the US is in means that there is another event that could push the greenback around. And the currency is likely to be particularly vulnerable over the next week.
US markets will be closed on Thursday, and only open for half a day on Friday. But many big traders might take more than those days off, which could mean the market has reduced liquidity. In the midst of that, the US Treasury is set to auction off almost $250B in debt. The market could react either to the results of the auction, or the impact of draining that much money from the markets. Or both.
Here’s What You Need to Know
The US government has a large deficit. Not as big as during covid, but more than double what it was pre-covid. That means it has to borrow a lot more money from money markets. Meanwhile, the traditional large buyers of US debt – China and Japan – are selling their debt. And so is the Fed. What this means is that demand for the bonds that the US government will be selling is expected to be significantly lower, even as the supply increases.
We previously went over how bond yields and prices affect the price of the dollar. Given that understanding, the conditions are set up for bond yields to rise according to the law of supply and demand. If bond traders think that yields will rise in the future, they won’t buy existing debt issuances, and hold out for better prices. This creates something of a self-fulfilling prophecy, as the bond issuer (in this case, the government) will have to offer higher yields to attract buyers.
Are We Running Out of Money?
Higher yields are important to forex traders, because that typically means the currency will rise. Lately, the dollar has been weakened on prospects that the Fed won’t hike rates, which has caused yields to fall. But in recent auctions, the Treasury has had difficulty finding enough buyers for their debt, and were forced to raise yields. That, in turn, has pushed the dollar higher in the past. The key thing here is that it already happened in situations where liquidity was normal. Now we are heading into a shortened trading week, with investors hesitant ahead of the release of the FOMC minutes.
One of the key indicators of how much “free” money is left is flashing a warning sign. That is the reverse repo facility at the Fed, where large institutions put their funds when they aren’t needed immediately. Those funds are available to be used to buy bonds, if investors think they can make money that way. Since peaking earlier in the year, over $1.6 trillion have been withdrawn from reverse repos, leaving just over $900B left.
Signs for the Future?
Where exactly is the “bottom” is a matter of speculation, but many analysts are worried that the rapid decline in reverse repos is a sign that liquidity in capital markets is fast running out. Not all of the funds in reverse repos can or will be used for buying treasuries. Higher yields might entice more of those funds to be used for buying treasuries, but that is exactly the issue: It means yields will rise, presumably supporting the dollar.
A lack of interest in buying US debt (a “lack of liquidity”, in more technical terms) would also increase speculation that the Fed might do something to ease the credit conditions of the markets. That could be in the form of slowing down its bond sales, which could cause the dollar to come back down. If the yields rise too much, the US could face a situation similar to that of the UK last year, which forced the central bank back into easing for a brief period. The Fed already did that once in March, so it’s not completely out of the cards.
