What will drive the US dollar in the short term?

Although the FX market appears to be laser-focused on central bank monetary policy, and particularly that of the Federal Reserve, it is worth pointing out again that none of this has led to any significant directional trends in the currency market, with the exception of the yen. Here there is clear monetary policy divergence between Japan and the rest of the G10 and the yen has risen accordingly. But elsewhere, central banks are largely easing in tandem, and this seems to be denying the FX market the opportunity to trade any significant policy divergence. Looking ahead, this seems unlikely to change.

We do sense that, if there are to be monetary policy surprises, they are most likely to come in the form of the Fed going slower than the market anticipates, while central banks in Europe go a little faster. This could conceivably work to support the US dollar but, even here, we sense that the resultant FX movement will be quite limit ed. Instead, it looks as if domestic politics, particularly in the US, and geopolitics will be the instigators of more significant currency volatility if, indeed, we do see some increase in volatility through the remainder of this year.

The US presidential election on November 5th is still on a knife edge. The FX market reflects this as shorter-dated implied volatility has picked up. The chart also shows how risk-reversals in euro/dollar have moved more in favour of dollar calls over puts, although this is, in part due to the fact that we have seen the euro/dollar spot rate drift down recently.

The Standard Bank’s view remains that euro/US dollar will continue to edge down towards the lower end of the 1.05-1.1275 range that has been in place for a long time now but that a decisive break below the bottom of this range will hinge on an election outcome that feeds the strong-dollar narrative. The trouble is that the market may be confused as to the most bullish or bearish outcome for the dollar.

In theory, a Republican clean sweep might be seen as the most bullish outcome for the US dollar, as this is likely to usher in, not just the tariff increases that former president Trump is proposing, but also tax cuts. His victory in 2016 was accompanied by Republican wins in the Senate and the House, cuts in the corporate tax rate, a surge in stocks, and a surge in the dollar. The same election result in 2024 could mean the same consequences for the dollar.

This being said, the postelection rally in the dollar ran out of steam by the time Trump took office in January 2017 and the whole of the following year saw the dollar decline by over 10% against other major currencies on the DXY index. In contrast, the victory for President Biden in 2020 saw the US dollar initially fall, only to reverse and move substantially higher through 2021 and 2022. Now clearly lots of things were happening during the presidencies of Trump and Biden that impacted the US dollar, such as the pandemic and the war in Ukraine.

Nonetheless, if there is a lesson from the last two elections it seems to be that the initial move in the dollar after the winner is declared is the opposite of the one we see through much of the president’s subsequent term in office. With this in mind, it seems understandable that traders and investors do not seem to be committing themselves too heavily when it comes to the US dollar this time around.

Ahead of the election, we’re still likely to see the market fascinated by monetary policy and, on this score, a likely 25-bps rate cut from the ECB this Thursday should be the main focus of the week. It seems that a part of the euro’s recent slide against the dollar can be put down to an apparent volte-face by the ECB on rate policy as its prior reticence to entertain the idea of a rate cut this week seems to have given way to clear acceptance of the need for a follow-up rate cut.

“The fact that this seems to be largely based on one sub-consensus inflation report is a bit worrying as it suggests that the ECB is very fickle at the moment; something that is likely to put any euro bulls on edge. However, the next significant directional move in euro/US dollar is more likely to come from either US politics, or geopolitics should events in Ukraine or Israel take a significant turn,” said the Standard Bank.