Dollars and Sense: The Short-Term Case for US Dollar Strength

US Dollar: The Attraction of Interest Rates Differentials

Interest Rate Differentials (IRDs) are commonly used by forex traders to leverage carry trade strategies, aiming to profit from the interest rate spread between low-yield and high-yield currencies.

Currently, the US dollar is looking the most attractive that it has in decades, driven mainly by the Federal Reserve's aggressive interest rate policies, which have pushed the yield on overnight deposits to approximately 5.3%.

This environment has led to a peculiar scenario where the Federal Reserve's rates on cash deposits surpass the yields on investment-grade corporate bonds, currently at about 5.2%.

Vincent Deluard, CFA, and Director of Global Macro Strategy at StoneX, notes the anomaly, adding "This is the first time in history that keeping cash at the Fed pays more than lending to corporations." He adds, “Looking at junk bonds, the current spread of 2.5% over the Fed Funds rate is also the lowest in history.”

This inversion of the risk premium, where the expected returns on risk assets fall below those on risk-free assets, comes at a time where there are no real extraordinary growth opportunities elsewhere either.

The stagnation of S&P 500 earnings per share (EPS) over the past two years, coupled with a modest growth forecast of 2.5% over the next year, underpins this view.

Deluard forecasts that the Federal Reserve might hold off on any Federal Funds rate adjustments in the short to medium-term, wary of contributing to resurgent inflationary pressures.

US Dollar: The Impact of Scarcity

Deluard highlights scarcity as another key factor propelling the US dollar forward in the near-term.

Scarcity, in economic terms, refers to the basic principle that resources are limited. In the context of the US dollar, scarcity can arise from many factors, including Federal Reserve policy decisions.

During the pandemic, the Federal Reserve aggressively bought assets like government bonds to inject money into the financial system, a process known as Quantitative Easing (QE). The Federal Reserve is in the process of now reducing its balance sheet following the pandemic, by approximately $100 billion per month, in a process known as Quantitative Tightening (QT).

QT reverses QE by letting these bonds mature without reinvestment or by selling them, thus pulling money out of the economy and causing US dollars to become increasingly scarce.

US Dollar: How Falling Liquidity Could Boost the USD

The Federal Reserve plays a key role in managing liquidity to ensure the US economy remains stable. One of the tools it uses to manage excess liquidity in the system is the Reverse Repo Facility.

Under the scheme, financial institutions buy securities from the Federal Reserve every day with an agreement to sell them back the next, with the profit from the transaction equating to the overnight interest for the cash loan.

This helps the Federal Reserve regulate the amount of money flowing through the economy and keep a grip on short-term interest rates. In its attempt to achieve a soft landing for the US economy, the Federal Reserve has the challenge of reducing its balance sheet and inflation, in tandem.

Deluard notes that from a liquidity perspective, the ‘everything rally’ that we’ve experienced over the past three months, has in large part been driven by the withdrawal of almost $700 billion from the Reverse Repo Facility since June last year.

And against the backdrop of QT and the overarching negative risk premium landscape, we could see Treasury debt offerings be well positioned to absorb the remaining excess liquidity exiting the Fed’s Reverse Repo Facility, which supports near-term bullish US dollar sentiment.

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