25.10.202208:43 Forex Analysis & Reviews: Dollar under pressure from Fed rates. Where will the pendulum swing?

The dynamics of the US currency largely depends on the Federal Reserve's strategy to the key rate. For a long time, the greenback has held a leading position thanks to the Fed being active. However, in the event of a pause in relation to raising rates on the part of the central bank, the USD will be in limbo, experts believe.

Last week, Fed officials admitted the possibility of some slowdown in the process of raising rates. According to Mary Daly, the head of the San Francisco Fed, the central bank does not plan to "permanently raise rates by 0.75%." At the same time, an increase in the interest rate by 75 bps, scheduled for the next meeting, November 2, is not in doubt. Experts admit that at the next December meeting, the Fed will raise the rate by only 50 bps, and not 75 bps, as previously expected.

Such statements provoked a rise in risk appetite and tripped up the dollar. On Monday evening, October 24, the EUR/USD pair, from which analysts expected a decline and exit from the converging triangle, went up. Having overcome the recent low at 0.9705, the pair rose to 0.9867. On Tuesday morning, October 25, the EUR/USD pair continued its upward trend and reached 0.9873. Against this background, the euro received significant support, maintaining a positive momentum and trying to keep the gained positions.

The short-term subsidence of the greenback, recorded on Monday evening, is due to disappointing macroeconomic data from the United States. Recall that in October, the composite PMI business activity index in the country decreased to 47.3 points. In September, this indicator was 49.5 points. At the same time, analysts were counting on its decline to only 49.3 points. In addition, in October, the index of business activity in the services sector in the United States "narrowed" to 46.6 points (from the previous 49.3 points), and in industry – to 49.9 points (in September – 52 points). At the same time, experts expected a slight decrease in indicators (up to 49.2 points and 51 points, respectively).

Many analysts fear that the quantitative tightening (QE) program, which the Fed adheres to, will provoke a significant drop in asset prices. Currently, the Fed is pursuing a policy of reducing its balance sheet by $95 billion per month, abandoning treasury state bonds and mortgage-backed securities. According to experts, this puts investors at risk, since during the sale of their bonds, the central bank "absorbs" liquidity in the market. This provokes an imbalance and weakens the greenback's position, experts believe.

Analysts and market participants expect the Fed to raise the interest rate for the fourth consecutive year (by 75 bps). Many are confident that the central bank will not stop this process until inflation drops to an acceptable level. Experts call the current Fed tightening cycle "the most aggressive in recent decades" and fear that it will provoke a recession in the global economy. Earlier, Reuters analysts conducted a survey according to which the probability of a recession within 12 months was 65%. Note that in the previous survey, this figure did not exceed 45%.

The US currency feels confident amid an active rise in Fed rates. Goldman Sachs currency strategists concluded that if the current trend continues, the dollar will peak next year. The bank's previous forecast assumed a sharp rise in USD in 2024. However, now the situation is developing in favor of the greenback due to the hawkish attitude of the Fed.

With a further increase in the interest rate in 2023, the dollar will receive an additional boost, Goldman Sachs is confident. In 2022, thanks to the "acceleration" of the Fed with a rate hike (in total by 300 bps) in 2022, the US currency was significantly ahead of its competitors. Against this background, reaching the peak of the USD price is a matter of the near future, the bank believes. At the same time, the markets expect that in 2023 the Fed will continue to follow the chosen course, and the rate cut will occur only in 2024.

In the medium term, the role of the US currency in the global financial system will be significantly reduced, experts believe. The reasons are the strengthening of the processes of de-dollarization in the world, the reduction of global foreign exchange reserves and the active use of digital national currencies. Colin Wise, an economist at the Fed, who has carefully analyzed scenarios for reducing the role of the USD as a global reserve currency, does not agree with these conclusions. According to the expert, a widespread rejection of the dollar is unlikely: even with a sharp reduction in its share in world reserves (up to 11.8%-17%), USD volumes will be twice as high as those of other currencies. According to IMF estimates, in the second quarter of 2022, global foreign exchange reserves denominated in dollars amounted to 59.5% of the total volume of currencies.