Dollar weakens by 0.8%

The trade-weighted dollar index has fallen by 0.8% today, reaching its lowest level since May. A similar move is observed on the EURUSD pair (+0.8%), which is approaching 1.17. We last observed such a significant weakening after the July Fed meeting, which led to investors withdrawing a large portion of their bets on interest rate hikes.

What stands behind today's move?

The main catalyst for the move was the US Treasury Department's announcement of plans to double its long-term US bond buyback operations. The program, aimed at supporting liquidity, will come into effect on 9 September and will last at least until 4 November.

Although technically this is not monetary policy easing, as this is the responsibility of the Federal Reserve, the effect from the market's perspective is similar. The decision means that more dollars will appear on the market, which naturally leads to the currency's depreciation.

Incidentally, in our opinion, this increases the probability of an interest rate hike by the Fed. Such a move could be treated as a balancing tool. We do not see any significant market reaction in this regard at the moment, as valuations still assign less than 50% probability to a hike in the autumn.

We are observing a significant drop in yields across the entire curve, particularly strong at its long end. We wrote about why this is good news for the stock market in today's US Open:

• For many years, especially in the second decade of the 21st century, bond yields remained at low levels (30-year ones around 3%), not constituting a real alternative to the stock market. This phenomenon even had a specific name, TINA, which stands for “there is no alternative”. Currently, many investors are starting to wonder whether it is worth taking the risk associated with stock market investments if the US government, as the world's safest debtor, offers a certain rate of return of 5.3% for 30 years.

In closing, it should be noted that bond yields still remain close to multi-year highs. In the case of 30-year bonds, the distance from the 19-year high is less than 14 bp.

Broader context

The US Treasury's decision is not the only factor weighing on the dollar. Over the last month, the currency has weakened by over 3%, which was driven by a significant repricing regarding the future path of Federal Reserve interest rates. Investors have withdrawn a significant portion of their bets on hikes, influenced both by unconvincing statements from Chairman Warsh and data from the US economy.

An unexpected drop in the number of new jobs and inflation readings that were in line with expectations or even slightly softer have influenced a shift in the market's baseline scenario. Over 50% of the market now prices in an interest rate hike only in December. The market seems increasingly convinced that the data has bought the committee some time, which will be needed to estimate the impact of the energy shock on the US economy.

What’s next?

Currently, attention is focused on the publication of the minutes, i.e., the record of discussions from the July FOMC meeting, scheduled for 6:00 PM. Investors will be looking for clues as to whether the Fed intends to keep current interest rates unchanged for a longer period.

Another significant test awaits the dollar next week, when the publication of PCE inflation is scheduled (26.08). This is a lagging measure, but historically preferred by the FOMC when making decisions regarding monetary policy. Kevin Warsh, however, spoke skeptically about it, calling the core PCE indicator a “scientific wild guess”.

It is possible that this topic will be discussed during the symposium in Jackson Hole (27-29.08), one of the two most important central banker conferences of the year. After the last Fed meeting, it seems clear that investors will be expecting a bit more clarity from Chairman Warsh at that time.

Michał Jóźwiak, Financial Markets Analyst at XTB