Fresh geopolitical tension in the Middle East has stirred the currency market once again. The US Dollar Index (DXY), which measures the value of the US Dollar against six major currencies, is holding onto its gains after two straight flat sessions and was trading around 100.90 during European hours on Tuesday. The main driver behind this strength was a return of safe-haven demand, because whenever uncertainty rises in the world, investors prefer to park their money in a trusted safe currency like the Dollar.
Hormuz tension shifts the mood
The whole episode centers on the Strait of Hormuz, one of the most important arteries for global oil trade. Late on Monday, word emerged that Iran fired at least two missiles at commercial vessels transiting the strategic waterway. Two ships sustained significant damage in the attacks, though there was some relief in the fact that no casualties were reported. Separately, the UK Maritime Trade Operations (UKMTO) confirmed that a southbound tanker was struck on its port side by an unknown projectile, which set the vessel ablaze. These incidents fueled a broad move away from risk, and it was the Dollar that benefited directly.
US data kept the rally in check
On the other side of the ledger, economic signals coming out of the United States held the Dollar's advance in check. Business activity in the service sector cooled slightly, yet it remained firmly in expansionary territory. The June ISM Services Purchasing Managers' Index (PMI) eased to 54.0 from 54.5, as expected and in line with consensus estimates. Digging into the sub-components of the report, the Prices Index dipped from 71.3 to 67.7, while the Employment Index showed a notable improvement, climbing out of contractionary territory from 47.9 to 51.2.
The cooling in jobs and business growth weighed on the Dollar's momentum, as traders scaled back their expectations for interest rate hikes from the central bank. Even so, the Greenback could find a solid floor of support from hawkish remarks by Federal Reserve Governor Christopher Waller and from resilient domestic economic data.
Why the Dollar is the world's most powerful currency
The US Dollar is the official currency of the United States of America, and it is also the de facto currency of a great many other countries where it circulates alongside local notes. It is the most heavily traded currency in the world. According to data from 2022, it accounts for more than 88% of all global foreign exchange turnover, which works out to an average of $6.6 trillion in transactions every single day.
Following the Second World War, the Dollar took over from the British Pound as the world's reserve currency. For most of its history, the US Dollar was backed by Gold, until the Bretton Woods Agreement in 1971 brought the Gold Standard to an end.
How the Federal Reserve steers the Dollar
The single most important factor affecting the value of the US Dollar is monetary policy, which is shaped by the Federal Reserve. The Fed has two mandates: to achieve price stability, meaning to control inflation, and to foster full employment. Its primary tool for meeting both of these goals is adjusting interest rates.
When prices are rising too quickly and inflation runs above the Fed's 2% target, the Fed raises rates, which supports the Dollar's value. Conversely, when inflation slips below 2% or the Unemployment Rate climbs too high, the Fed may lower interest rates, which weighs on the Greenback.
The push and pull of QE and QT
In extreme situations, the Federal Reserve can also print more Dollars and enact quantitative easing (QE). QE is the process by which the Fed substantially increases the flow of credit in a stuck financial system. It is a non-standard policy measure used when credit has dried up because banks refuse to lend to one another, out of fear that the other party might default. It is a last resort deployed when simply lowering interest rates is unlikely to deliver the necessary result.
It was the Fed's weapon of choice to combat the credit crunch that struck during the Great Financial Crisis in 2008. It involves the Fed printing more Dollars and using them to buy US government bonds, predominantly from financial institutions. QE usually leads to a weaker US Dollar. Quantitative tightening (QT) is the reverse process, in which the Federal Reserve stops buying bonds from financial institutions and does not reinvest the principal from the maturing bonds it already holds into new purchases. This is usually positive for the US Dollar.
How other markets are trading
Elsewhere in the currency market, GBP/USD extended its winning streak to a ninth consecutive day, trading around 1.3390 during Asian hours on Tuesday. The pair pushed higher as the Dollar faced headwinds, with market participants scaling back expectations for rate hikes from the central bank this month and in September.
EUR/USD, meanwhile, was easing toward 1.1400 in European trading on Tuesday, running into rejection at the 1.1450 level. The pair lost ground amid a modest recovery in the safe-haven Dollar, as renewed tension in the Strait of Hormuz and a sell-off in Asian tech stocks fueled risk aversion.
Gold kept an offered tone heading into the European session, though it held above the $4,100 mark. Crude oil prices edged higher amid the renewed Hormuz tension, reviving inflationary concerns. That in turn triggered a fresh leg up in US Treasury bond yields, offering some support to the Dollar and weighing for a second straight day on the non-yielding yellow metal.
Bonk under pressure in crypto
In the crypto market, Bonk remained under pressure, trading below $0.0000044 after shedding more than 10% in the previous day's session. Monday's correction unfolded after the Bonk Decentralized Autonomous Organization (DAO) disclosed a governance exploit that led to the theft of $20 million worth of BONK tokens from its treasury.
Central banks changing their tune
For years, central banks have spent their energy telling markets what might come next. Now, traders face the possibility that they will say a lot less. From the Federal Reserve to the European Central Bank and the Bank of England, policymakers are pushing back against forward guidance. For the market, that means reading the road ahead could become even harder.
