The US dollar index (DXY), which tracks the greenback’s value against a basket of six major currencies, edged lower on Monday as traders assess the evolving situation in the Middle East. At the time of writing, the index is trading around 99.95 after hitting 100.21 at the start of the day, its highest level since April 6.
The greenback initially extended its recent rally as the market continued to digest Friday’s stronger-than-expected US nonfarm payrolls (NFP) report, while renewed hostilities between Iran and Israel over the weekend further boosted demand for the safe-haven US dollar.
However, the US dollar reversed gains after Iran’s Fars News Agency reported that Iran had ended its military operations against Israel.
This development maintains hope that a comprehensive peace agreement is possible in the Middle East. US President Donald Trump said negotiations with Tehran were still ongoing, although he warned that a US naval blockade of Iranian ports would remain in place until a final agreement was reached.
Nevertheless, the situation remains volatile, limiting deeper losses in the US dollar. At the same time, rising expectations of an aggressive Federal Reserve (Fed) stance continue to support the greenback.
According to a report from Brown Brothers Harriman (BBH), “USD may continue to rise against most major currencies as the US macro backdrop of improving labor demand and sticky inflation supports a more restrictive Fed policy stance.”
According to the CME FedWatch tool, traders expect the Fed to keep interest rates unchanged in the coming months, with the possibility of continuing to raise rates through the end of the year.
Traders will now turn their attention to US inflation data due later this week for new clues on the Fed’s monetary policy outlook. Inflation continues to rise due to higher energy prices, with the annual consumer price index (CPI) forecast to rise to 4.2% in May from 3.8% a month earlier.
Meanwhile, the latest Survey of Consumer Expectations (SCE) released on Monday by the New York Fed indicated that long-term inflation expectations remain well anchored. Inflation expectations over the three-year and five-year forward horizons remained unchanged at 3.1% and 3.0%, respectively.
US Dollar FAQ
The US dollar (USD) is the official currency of the United States, and the ‘de facto’ currency of many other countries where it is found in circulation along with local notes. According to 2022 data, it is the most traded currency in the world, accounting for more than 88% of all global foreign exchange turnover or an average of $6.6 trillion transactions per day. After the Second World War, the USD took over from the British Pound as the world’s reserve currency. For most of its history, the US dollar was backed by gold, until the Bretton Woods Agreement in 1971 when the gold standard ended.
The most important factor influencing the value of the US dollar is monetary policy, which is shaped by the Federal Reserve (Fed). The Fed has two mandates: to achieve price stability (control inflation) and to promote full employment. Its primary tool to achieve these two goals is to adjust interest rates. When prices are rising too fast and inflation is above the Fed’s 2% target, the Fed will raise rates, which helps the USD value. When inflation falls below 2% or the unemployment rate is very high, the Fed may lower interest rates, which has an impact on the greenback.
In extreme situations, the Federal Reserve may even print more dollars and implement quantitative easing (QE). QE is the process by which the Fed substantially increases the flow of credit into a stuck financial system. This is a non-standard policy measure used when credit is lost because banks will not lend to each other (for fear of counterparty default). It is a last resort when simply reducing interest rates is not likely to achieve the required results. It was the Fed’s preferred weapon to deal with the credit crunch that arose during the great financial crisis in 2008. This involves the Fed printing more dollars and using them to buy US government bonds, primarily from financial institutions. QE usually leads to a weakening of the US dollar.
Quantitative tightening (QT) is a reverse process whereby the Federal Reserve stops purchasing bonds from financial institutions and does not reinvest the principal from maturing bonds in new purchases. This is generally positive for the US dollar.
