Navigating the Shifting Tides: The Dollar's Uncertain Future

The US dollar has been on a rollercoaster ride, with its recent rebound raising questions about its long-term trajectory. As the market grapples with the implications of China's stimulus measures and the Federal Reserve's policy decisions, the path forward for the greenback remains uncertain. This article delves into the factors shaping the dollar's fortunes and explores the potential scenarios that could unfold in the coming months.

Riding the Waves of Volatility: The Dollar's Unpredictable Journey

The Dollar's Rebound: A Temporary Respite?

The US dollar index scored its biggest daily rise since June, as the yield on the 10-year US Treasury note surged past the 3.8% mark, reaching its highest level in three weeks. However, this rebound may be short-lived, as the soft landing narrative remains intact, and markets continue to favor more aggressive rate cuts by the US Federal Reserve (Fed). The path of least resistance for the dollar appears to be lower in the short term.

China's Stimulus: A Potential Game-Changer

Another factor that could weigh on the dollar is the stimulus being pumped by China. Investors have received a fresh boost of optimism from news of a possible capital injection ($142bn) into China's top banks, in addition to several other support measures announced earlier this week. This should continue to buoy risk-sensitive currencies, including the British pound (GBP), as well as commodity-linked currencies such as the Australian dollar (AUD), Canadian dollar (CAD), and Norwegian krone (NOK). The euro (EUR), which has China as its largest trading partner, should also benefit from these developments. Consequently, this could keep the dollar bulls on the backfoot.

Macroeconomic Indicators: A Mixed Bag

On the macroeconomic front, the data was sparse yesterday, but one notable development was the surge in US mortgage applications for a second consecutive week, reaching a new 2-year high. This increase in demand was in line with the continued drop in benchmark mortgage rates, as the outlook of a dovish Fed kept the yield on long-term Treasuries in check. However, the focus will now shift to the release of US GDP data and weekly unemployment claims, while the Fed's preferred measure of inflation, the core PCE deflator, is due tomorrow. A low reading, such as 0.1% month-over-month, could deliver a fresh leg lower in the dollar.

The Pound's Pullback: A Temporary Correction

Apart from escalating geopolitical tensions, there have been no obvious news triggers driving the pullback in the British pound from its over 2-year highs. However, as noted previously, the technical setup pointed towards this happening, as the currency had reached overbought conditions against both the euro and US dollar, according to the Relative Strength Index (RSI) readings on the daily charts.The daily decline in both exchange rates has already dragged them out of the overbought zone, with the RSI back into the equilibrium band. Growth and yield differentials continue to provide a bullish outlook for the pound, with $1.35 on GBP/USD a potential upside target in the short term. The pound's high beta to risk also puts it in a favorable position, so long as global risk appetite remains upbeat. Nevertheless, with the US election just over a month away, safe-haven dollar demand could start picking up, given the elevated uncertainty about the outcome.

The Euro's Struggle to Break Through $1.12

Amid quarter-end flow-induced volatility, the euro briefly touched $1.1214, its highest level since July 2023. However, this threshold again proved unsustainable, with EUR/USD trading above the $1.12 level for only six sessions over the past 30 months. The pair ultimately closed lower on Wednesday, though it remained the best performer across the G10 currencies.The weakness in the euro was partly driven by Bunds falling the most in a week, led by the belly of the curve, as money markets pare ECB wagers on terminal rates. While year-end rate cut bets remained steady, traders trimmed as much as 8bps from next year's meetings.European equities also posted losses for a second consecutive day, with the Stoxx50 struggling to breach the 4950 level. A month ago, we highlighted the risk of equity market fatigue, suggesting that 5000 could act as a ceiling for potential gains, a scenario that has materialized. Despite a 7% rebound since the August trough, European equities remain in a broad downward-trending channel since the May peak, driven by deteriorating macroeconomic fundamentals, which have made euro-denominated assets less attractive.Looking ahead, the market enters a period that has historically seen sharp downturns in equity performance, potentially acting as a headwind as we enter the fourth quarter.

Commodity Currencies Shine Amid China's Stimulus

In terms of other euro crosses, the common currency appreciated against all G10 peers except the US dollar. The euro saw the strongest gains against high-beta commodity currencies such as the Norwegian krone (NOK), New Zealand dollar (NZD), and Australian dollar (AUD). EUR/SEK rose by over 0.4%, rebounding from a near three-month low after the Riksbank lowered its key policy rate by 25 bps to 3.25%, signaling further potential cuts.Central bank projections suggest one or two additional cuts in early 2025, contingent on inflation and economic conditions. Until the ECB clarifies its stance on the October meeting, where policymakers have resisted a back-to-back rate cut, but the market has priced in a 60% probability, EUR/SEK may continue to trend higher, especially with the RSI near oversold levels.

Oil Prices Slide Amid Broader Market Uncertainty

In the commodity markets, oil prices have declined by over 6% in the past week, reflecting the broader market uncertainty and concerns about global economic growth. This downward trend in oil prices could have implications for commodity-linked currencies, such as the Canadian dollar and Norwegian krone, which are closely tied to the energy sector.As the global economy navigates these turbulent times, the fate of the US dollar remains closely intertwined with the actions of central banks, geopolitical developments, and the overall market sentiment. Investors will need to closely monitor the evolving landscape to make informed decisions and position themselves for the potential shifts in the currency markets.