The Israel War Extends and the US Dollar Too

Elevated inflation in the United States did not boost risk appetite, despite the S&P 500 showing an initial lack of negative response to the increased CPI reading and higher yields. However, it appears that another lacklustre UST bond auction served as the catalyst for a sustained sell-off. The S&P 500 plummeted by 1.4% from its high near the close of the London trading day to an intraday low about two hours later. While the equity market did see a rebound, it still closed by 0.6%.

During the 30-year UST bond auction held the previous day, the yield reached 4.837%, which was nearly 4 basis points higher than the pre-auction trading yield. This occurred despite the auction being the highest yielding since 2007. The 3-year auction on Tuesday saw a yield of 4.74%, the highest since February 2007, and it tailed by nearly 2 basis points with a bid-to-cover ratio of 2.56, the lowest since February. The 10-year auction also tailed by close to 2 basis points, although the bid-to-cover ratio was somewhat better at 2.50, compared to the six-month average of 2.44. Nevertheless, the supply of UST bonds continues to pose challenges to the US Treasury market due to the unprecedented fiscal outlook for the United States.

The current state of the fiscal deficit is a cause for alarm. The White House, in a recent blog post, attributed the current deterioration in the fiscal position to the tax cuts introduced during the Trump administration. In the first eleven months of the fiscal year, the US fiscal deficit has surged by a substantial 60%, reaching USD 1.52 trillion. This represents an unprecedented deficit increase during a year in which the economy has been expanding by over 2.0%. The Tax Cuts & Jobs Act, which included substantial tax cuts, has significantly reduced the government's ability to generate tax revenues, such as capital gains tax.

The IMF's Fiscal Monitor, released this month, estimates that the US fiscal deficit for this year stands at 8.2%. Over the five years leading up to 2028, it is projected to average a still significant 7.1%. This level of deficit is unsustainable and further underscores the risk of higher yields in the US, which could create increasingly unfavourable financial market conditions, ultimately supporting the US dollar. The correlation between the DXY (Dollar Index) and the S&P 500 has been weakening, but it remains negative. This reflects the recent rebound in equities, though the sustainability of this rebound remains uncertain. The more mid-cap-focused Russell 2000 fell by 2.2% the previous day and is down by 13.5%, nearing recent lows. If further equity selling ensues, it could potentially intensify and provide support for the US dollar.

In FX market, the higher-than-expected US CPI triggered some profit-taking and provided a fresh boost to the USD across the board. The increase in long-term US yields also played a role in bolstering the USD, and this led investors to recalibrate their expectations for a potential final rate hike by the Federal Reserve later this year, with particular attention on the upcoming 14 December FOMC meeting. However, the likelihood of such a rate hike remains below 50%, potentially posing a hurdle to a more robust USD rally that could propel the DXY back to its year-to-date peak of 107.34, which it achieved earlier this month.

The EUR-USD and GBP-USD pairs continue to trade close to 1.0550 and 1.22, respectively, which is below the highs seen earlier this week at 1.0639 and 1.2337 but still significantly above this month's lows of 1.0449 and 1.2038. On the other hand, the JPY faces a more challenging situation, slipping back to near 150 against the greenback, which has reignited concerns of potential intervention by the Bank of Japan (BoJ).

For EUR-USD to regain investor confidence in its potential for further upside, it must hold above the 1.05 level and swiftly reclaim the 1.06 mark. This will be a critical factor in determining the future trajectory of this currency pair.

This content may have been written by a third party. ACY makes no representation or warranty and assumes no liability as to the accuracy or completeness of the information provided, nor any loss arising from any investment based on a recommendation, forecast or other information supplied by any third-party. This content is information only, and does not constitute financial, investment or other advice on which you can rely.