Dollar slides as Treasury steps into bond market
Market overview
FX markets begin Thursday digesting a sharp fall in the dollar after the US Treasury unexpectedly increased the scale of its long-term bond buyback programme. The Treasury will at least double the maximum size of purchases in the 10-to-30-year maturity sectors from $2 billion to $4 billion per operation, beginning on 9 September. The announcement immediately eased pressure on the bond market, pulling the 10-year Treasury yield down from around 4.71% to 4.65% and the 30-year yield back towards 5.20%.
The dollar absorbed much of the adjustment. The DXY index fell more than 0.8% to around 98.85, its lowest level since late May, while EUR/USD broke decisively above 1.16 and GBP/USD briefly reached 1.3630. Federal Reserve minutes released later in the session were relatively cautious on inflation, but struggled to reverse the move. Sterling has had more mixed fortunes: it has advanced against the dollar but slipped towards its lowest level against the euro since early July, highlighting how differently currencies are responding to the renewed focus on government debt and borrowing costs.
USD: Treasury intervention puts the dollar in the firing line
The dollar suffered its largest daily decline in several weeks after the Treasury surprised markets with a significant expansion of its debt buyback programme. The maximum size of individual liquidity-support purchases for 10-to-30-year bonds will rise from $2 billion to at least $4 billion between 9 September and 4 November, a response to the recent deterioration in long-term Treasury market conditions.
The move helped reverse part of the recent surge in borrowing costs. Thirty-year Treasury yields had climbed above 5.30% earlier this week, their highest level since 2007, before falling towards 5.20% following the announcement. Ten-year yields also dropped towards 4.65%. Although the Treasury describes the programme as a measure to improve market liquidity, investors have interpreted the intervention as evidence that policymakers are becoming increasingly uncomfortable with the level of long-term borrowing costs.
For the dollar, the implications are less supportive. Lower long-term yields reduce part of the return advantage offered by US assets, while the intervention also raises questions over whether the currency will increasingly act as the adjustment mechanism when policymakers seek to prevent Treasury yields from rising further. GBP/USD climbed as high as 1.3624 following the announcement, while EUR/USD reached around 1.1667.
The Federal Reserve minutes offered a counterweight but failed to generate a lasting recovery. Nine members voted to leave the policy rate at 3.50%-3.75% in July, while three preferred an immediate 25 basis-point increase. Most policymakers still expected inflation to moderate over the remainder of the year, although many warned that price pressures could prove more persistent and judged the risks around inflation to remain skewed to the upside.
That leaves the dollar caught between a Federal Reserve still reluctant to declare victory over inflation and a Treasury increasingly active in trying to contain long-term borrowing costs. Today’s US data will provide the next test. Weekly jobless claims are expected at around 210,000 after 209,000 previously, while the Philadelphia Fed manufacturing index is forecast to retreat sharply to around 24 from July’s unusually strong 41.4 reading.
GBP: Stronger against the dollar, weaker against the euro
Sterling’s performance illustrates the unusual nature of the current market move. GBP/USD climbed to a three-month high around 1.3630 on Wednesday as the dollar sold off, but the pound simultaneously weakened against the euro. GBP/EUR fell as low as 1.1648, its weakest level since 1 July, before stabilising around the mid-1.16s this morning.
The explanation lies partly in the scale of the dollar move. EUR/USD rose by more than GBP/USD following the Treasury announcement, automatically pushing GBP/EUR lower. The euro also appears to be attracting greater demand as investors seek alternatives when concerns are centred specifically on US government debt, while the UK’s own fiscal position and relatively high borrowing costs make sterling a less obvious destination.
Domestic rate expectations are providing little additional support. Wednesday’s inflation figures showed headline CPI rising to 2.9% from 2.6%, but much of the increase reflected higher energy costs. More importantly for the Bank of England, services inflation eased and earlier labour-market figures showed wage pressures continuing to cool. Markets now attach only around a 13% probability to a September Bank rate increase, leaving the pound with considerably less interest-rate support than it enjoyed earlier in the summer.
The fall in global bond yields following the Treasury announcement offers some welcome relief for the UK, where long-term borrowing costs had risen particularly sharply. However, the underlying vulnerability has not disappeared. If sovereign yields resume their climb because of fiscal concerns or renewed energy-driven inflation, sterling could again struggle against currencies perceived as less exposed to government financing risks.
Friday’s UK releases should therefore take on greater significance. July retail sales will show whether consumer resilience continued after June’s 1.0% monthly increase, while the flash PMIs offer a more timely assessment of growth momentum. Manufacturing is expected to remain close to 52, keeping the sector modestly in expansion territory, while the wider composite index will be watched closely after reaching 52.2 in July.
EUR: Euro breaks higher as dollar weakness does the heavy lifting
EUR/USD has been the clearest beneficiary of the renewed pressure on the dollar, surging through 1.16 on Wednesday and posting its largest daily advance since March. The move carried the pair towards 1.17 and produced its first daily close above the 200-day moving average since May, strengthening the technical picture after several weeks of consolidation.
As with much of the euro’s recent appreciation, however, the catalyst originated in the US rather than Europe. The Treasury buyback announcement pushed US yields lower and reinforced concerns that the dollar may increasingly bear the cost of attempts to contain American borrowing costs. That shift in the rate differential has provided EUR/USD with fresh momentum even without a new eurozone-specific catalyst.
The euro does nevertheless have a firmer domestic backdrop than earlier in the year. Eurozone GDP expanded 0.4% in the second quarter and recent economic surprises have generally improved. Markets also continue to expect the ECB to raise rates at its September meeting, helping German yields remain comparatively well supported and adding to the euro’s relative rate appeal.
There is a risk that those expectations have moved too far. Danske Bank expects the ECB to deliver one final increase in September but argues that markets are pricing more subsequent tightening than is likely to materialise. A less hawkish ECB path could therefore take some support away from the euro. For now, however, improving European growth data and continued demand for European assets mean that betting aggressively against the currency remains difficult.
Friday’s flash PMIs will provide the next domestic test. Eurozone manufacturing is expected to remain in expansion territory at around 51.8, compared with 51.9 previously, while the composite reading will be watched for evidence that July’s improvement to 52.0 is being sustained. A resilient release would strengthen the case for September tightening and could help EUR/USD consolidate its break above 1.16.
Looking ahead
US jobless claims — Thursday: Initial claims are expected at around 210,000, compared with 209,000 last week. A significant increase would reinforce signs of gradual labour-market cooling and could add to pressure on the dollar.
Philadelphia Fed manufacturing — Thursday: The headline index is forecast to fall to around 24.3 from 41.4. July’s figure was exceptionally strong, so some normalisation is expected; a sharper decline would add to evidence that US momentum is moderating.
UK consumer confidence — Thursday evening: The GfK index is expected to remain around -17, following July’s six-point improvement. A further rise would suggest households are proving relatively resilient despite higher energy costs and inflation.
UK retail sales and PMIs — Friday: Retail sales rose 1.0% month-on-month in June. Manufacturing PMI is expected around 52.0 versus 51.9 previously, while services and the composite measure will be watched for signs that the recent improvement in activity is continuing.
Eurozone PMIs — Friday: Manufacturing is forecast around 51.8 from 51.9, with the broader composite index looking to hold close to July’s 52.0 reading. Resilient figures would support expectations for a September ECB rate increase.
US PMIs — Friday: Manufacturing is expected to ease to around 53.5 from 53.9, while services are forecast around 53.9 from 54.6. Continued moderation would reinforce the recent reduction in expectations for further near-term Fed tightening.
Treasury yields: The durability of Wednesday’s bond-market relief remains an important wider FX driver. The Treasury’s larger buybacks have reduced long-end yields for now, but high debt issuance, inflation uncertainty and fiscal concerns remain structural pressures. A renewed rise in yields could quickly return sovereign debt risk to the centre of currency markets.