Investors expect the Federal Reserve to start a rate-cutting cycle, wiping out the US dollar's full-year gain in 2024

The US dollar weakened this quarter, almost wiping out the gains of 2024, as traders anticipate the Federal Reserve may soon relax monetary policy by cutting interest rates.

According to data from FactSet reported by the Wisdom Financial APP, as of Wednesday, the US Dollar Index fell by 0.54%, deepening its decline to over 4% for the quarter. This decline has kept the index—measuring the performance of the US dollar against other major currencies—almost flat for the year.

Deutsche Bank's Global Head of Currency Research, George Saravelos, stated in an email sent on Wednesday: "Since August, the market is currently pricing in a relatively large easing cycle by the Federal Reserve, with expectations that the US dollar will lose its status as one of the top 3 high-yield currencies by next year. This will be a significant development and will push the US dollar into a more bearish state within our framework."

Saravelos further pointed out, "So the key question for our medium-term US dollar view is: do we agree with this pricing? We do not. As long as the US dollar remains a high-yield currency, there is strong evidence to suggest it will remain robust."

Deutsche Bank's research indicates that the US economy is outperforming market expectations for GDP growth, contrasting with the situation in Europe.

Despite a recent increase in the US unemployment rate and some "slack" in the labor market, Saravelos explained that the US benefits from immigration, stating, "If the primary driver is positive supply shocks, then even with rising unemployment, the economy may still continue to grow."

Saravelos also believes that it is difficult for the US "terminal rate" to be lower than countries facing more severe supply-side issues, such as the UK. He also questioned whether the US terminal rate would be lower than countries entering a recession (like New Zealand) or lower than countries that have never raised rates too high (like Australia).

Meanwhile, Saravelos noted that the US fiscal policy seems to be "loose regardless of the upcoming election results," and compared to other countries in the world, the US economy has a lower sensitivity to interest rates Investors expect that the Federal Reserve will begin to cut interest rates later this month. According to the CME FedWatch Tool, as of Wednesday afternoon, traders in the federal funds futures market believe there is a 57% chance of a quarter-point rate cut by the Fed, while the probability of a half-point rate cut is lower at 43%.

Saravelos pointed out that historically, the Federal Reserve has rarely implemented a half-point rate cut during or after an "emergency meeting." If the Fed proactively initiates a series of rate cuts, it could weaken the US dollar as it would signify a historic shift in the Fed's reaction function and lead to a narrowing of short-term interest rate differentials.

However, he believes that a proactive Fed also implies that "the likelihood of ultimately settling at a higher level of rates will increase," making the medium-term outlook for the US dollar uncertain.

As of Wednesday, based on the CME FedWatch Tool, federal funds futures indicate that the Fed's policy rate could drop to around 3% within the next 12 months. The Fed will announce its rate decision after concluding a two-day policy meeting on September 18th. Saravelos stated, "The key uncertainty for the year-end dollar outlook is the strategy of the upcoming easing cycle by the Federal Reserve."