US Dollar Index (DXY) trims losses as the aftermath of the US midterm elections becomes clearer

Thursday sees the US Dollar Index (DXY) trim its decline as markets digest the US midterm election results.
The Greenback draws support from recent US figures showing robust labour demand and firm activity in services and manufacturing.
Confidence in a December Fed rate rise persists, giving investors another reason to avoid sizeable US Dollar short positions.

The US Dollar Index (DXY) stands at 101.50 at the time of writing. Having rebounded from Asian-session lows of 101.20, it is virtually unchanged on the day. The US Dollar (USD) is recovering earlier losses on Thursday as investors turn from the US midterm election results towards this week’s robust US economic releases. Those figures clear the way for another Federal Reserve (Fed) interest rate rise in December.

TMGM Analysis: Financial Market News, Economic Calendar & Market Insights

Recent US economic releases reinforce evidence of strong momentum, helping to cushion USD declines. A modest appetite for risk, alongside the recent fall in Oil prices and retreat in US Treasury yields, nevertheless continues to limit any substantial US Dollar rebound.

US labour figures top forecasts; manufacturing and services activity stays firm

Net employment increased by 86K in October, according to the ADP Employment report, exceeding the market forecast of 69K. The US ISM Services Purchasing Managers' Index eased to 54.5 in October from September’s 54.9. Despite the modest slowdown, the reading remained consistent with healthy sector activity. Its employment sub-index rose, while inflation held at elevated levels. Monday’s ISM Manufacturing PMI painted a comparable picture. Together, the releases suggest the US economy entered the fourth quarter at a strong pace.

An 81% probability of a quarter-point rate rise next month is priced in, according to the CME’s FedWatch Tool. Expectations for a December Fed increase therefore remain high against this backdrop. Investors are watching Friday’s Nonfarm Payrolls (NFP) report, although only a disastrous result would shift that assessment.

That assessment is shared by experts at some of the world’s leading commercial banks. Citing fundamentals that remain solid, MUFG analysts say they “would not interpret the post-election fall in US yields and the dollar as the beginning of a broad USD sell-off yet,” rather than viewing the move as a broader reversal. MUFG specifically notes that “US private payrolls rose by 86k in October, beating the 67k consensus and reinforcing signs of resilient labour demand following Tuesday’s stronger JOLTS print,” indicating that underlying support for the Dollar remains intact for now.

ING experts likewise see limited room for a more pronounced Dollar decline. In their view, “a still-resilient US economy and at least one more rate hike from the Federal Reserve” are likely to “limit a larger dollar correction.”

US Dollar: Key Questions

What role does the US Dollar play?

Over 88% of global foreign exchange turnover involves the US Dollar (USD). Based on 2022 data, this represents average daily transactions of $6.6 trillion, making it the world’s most actively traded currency. As well as being the official currency of the United States of America, it serves as the ‘de facto’ currency in a significant number of other countries, circulating alongside local banknotes. The USD replaced the British Pound as the global reserve currency after the Second World War. Gold backed the US Dollar for most of its history, until the Bretton Woods Agreement in 1971 brought the Gold Standard to an end.

How does Federal Reserve policy affect the US Dollar?

Monetary policy set by the Federal Reserve (Fed) is the single biggest influence on the US Dollar’s value. The Fed’s two mandates are price stability, meaning control of inflation, and full employment. Interest rate adjustments are its main means of pursuing both objectives. The Fed raises rates when prices climb too rapidly and inflation exceeds its 2% target, supporting the USD. Conversely, inflation below 2% or an excessively high Unemployment Rate may prompt rate cuts, putting pressure on the Greenback.

How does Quantitative Easing work, and what does it mean for the US Dollar?

In extreme circumstances, quantitative easing (QE) allows the Federal Reserve to print additional Dollars and substantially expand credit flows through a stalled financial system. This unconventional policy is used when credit dries up because banks fear counterparty defaults and stop lending to one another. It is a last resort when interest rate cuts alone are unlikely to deliver the required outcome. During the Great Financial Crisis in 2008, QE was the Fed’s preferred response to the credit crunch. The process involves printing more Dollars to purchase US government bonds, chiefly from financial institutions. A weaker US Dollar is the usual result.

How does Quantitative Tightening work, and what does it mean for the US Dollar?

Usually supportive of the US Dollar, quantitative tightening (QT) reverses this process. The Federal Reserve halts bond purchases from financial institutions and no longer reinvests the principal from maturing bonds in its portfolio in new purchases.