by Bryan Perry
September 24, 2024
As the stock market celebrated new all-time highs last week, the U.S. dollar has taken on a quite different tone, raising concerns about the direction of the world’s premier reserve currency. The foreign exchange (Forex) market is the largest and most liquid market in the world, trading trillions of dollars each day. Key participants are central banks, commercial banks, investment banks, hedge funds, sovereign funds, Forex brokers and retail investors. The Forex market operates 24 hours a day, five days a week.
The anticipation leading up to the Fed’s half-point rate cut last week had traders pressuring the dollar to a closely-watched technical level – that being 100 on the U.S. Dollar Index (DXY), which measures the U.S. dollar relative to a basket of six major currencies – the Euro, Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. The DXY is most heavily weighted in the Euro because the continental currency represents the largest and most significant trading partner of the U.S. among the DXY index:
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Over the past six months, the Euro is up 3.19% to the dollar, the Pound Sterling is +5.82%, the Canadian Dollar +0.27%, the Japanese Yen +5.32%, the Swedish Krona +1.98% and the Swiss Franc is up 5.88%. These gains are influenced by central bank monetary policy and government fiscal policy, and though these six economies carry some weight, they pale in size and significance to the U.S. economy.
The global GDP in 2023 was approximately $105.4 trillion, of which the U.S. economy accounted for $27.4 trillion, or roughly 26% of total global GDP. The U.S. economy drives the global bus of economic growth. If the U.S. slides into recession, it has a major ripple effect. A stable dollar is vital to the stability of world trade, especially oil. At present, there are 23 countries whose currencies are pegged to the U.S. dollar, including Hong Kong, Saudi Arabia, the UAE, Qatar, Oman, Jordan, Oman, and even Venezuela.
The Fed’s recent slashing of rates is intended to maintain the notion of a soft landing. At the same time, the Fed is currently reducing its bloated $7.1 trillion balance sheet, but at a slower pace than before. In a slowing economy, this process, called Quantitative Tightening, or QT, can exacerbate an already slowing economy, but the Fed also stated that the economy was stronger now. Reduced liquidity can lead to tighter financial conditions, but the market senses that the lower Fed funds rate will provide a strong offset.
Of importance here is how the dollar responds to the converging bearish forces of falling interest rates and a soaring national debt, currently increasing at a pace of $1 trillion every 100 days, now standing at $35.4 trillion. Neither Kamala Harris nor Donald Trump have said much about the nation’s deficits on the campaign trail, suggesting that the spending spree will only worsen in the next four years. Based on recent estimates, spending on older Americans (Medicare and Social Security) is set to spike, so a new administration and Congress need to figure out a way to reach some bipartisan goals on fiscal policy.
At present, the bond and stock markets do not seem much concerned about what the soaring deficit, which will likely reach an inflection point sooner than most expect. Recent Treasury auctions are being met with decent demand, but one has to wonder about how much debt the global market will absorb before it demands a higher coupon to compensate for a dollar that has entered a new downtrend.
Not having a crystal ball, I’d just keep an eye on the DXY, to see if it crosses below the 100 support level.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
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