Why does the USD outlook depend on UST and Fed policy credibility?

The U.S. dollar's future trajectory is under scrutiny, with BofA Securities highlighting significant downside risks stemming from the U.S. Treasury's recent actions and the Federal Reserve's potential policy responses. The core concern revolves around the credibility of American economic policy, particularly the Treasury's efforts to manage long-term borrowing costs. This analysis suggests that without corresponding fiscal restraint, the dollar's exchange rate may become the primary mechanism for adjustment, leading to its depreciation.

BofA Securities' Analysis

BofA Securities has expressed skepticism regarding the U.S. Treasury's recent announcement to increase long-dated bond buybacks. The bank views the timing of this announcement, outside the usual quarterly refunding process, as an indication that the Treasury's primary goal is to suppress long-term yields rather than merely improve market liquidity. This approach, if not balanced with fiscal discipline, could undermine confidence in U.S. policy, making the dollar vulnerable to further declines.

The analysis from BofA suggests that if the Federal Reserve adopts an accommodative stance, potentially by absorbing increased Treasury bill issuance onto its balance sheet, it would further strengthen the argument for selling the dollar. This scenario would particularly favor higher-beta currencies, as investors seek alternatives to a weakening greenback. The observed weakness across both funding and risk-sensitive currencies points towards structural issues for the dollar, rather than just a temporary reaction to interest rate changes.

Treasury's $4 Billion Buybacks

The U.S. Treasury's plan to at least double the maximum size of long-dated bond buybacks to $4 billion per operation, from $2 billion, between September 9 and November 4, is a key driver of the current dollar outlook. This aggressive move to contain long-term borrowing costs has already had an immediate impact on currency markets. Following the announcement, the greenback weakened, while safe-haven assets like gold and the Swiss franc saw outperformance.

Furthermore, U.S. equities experienced declines despite lower 10-year Treasury yields, which BofA interprets as a renewed concern among investors about the overall credibility of U.S. policy. The market's reaction suggests that while lower yields might typically support equities, the underlying apprehension about the Treasury's strategy and its implications for the dollar is overriding this effect. This indicates a deeper structural concern rather than a simple interest rate play.

NZD/USD at 0.5957

In response to the anticipated dollar weakness, BofA Securities has adjusted its trading recommendations, adding to its dollar shorts. Specifically, the bank is recommending a long position in NZD/USD at 0.5957, targeting 0.62 with a stop at 0.58. This recommendation is underpinned by several factors, including the expectation of two additional rate increases from the Reserve Bank of New Zealand, which would make the New Zealand dollar more attractive.

Beyond monetary policy, BofA also considers external factors that could bolster the New Zealand dollar. Potential weather-related disruptions to global food supplies are cited as a possible support for New Zealand's export prices and, consequently, its currency. Technically, the NZD/USD pair has shown constructive signs, breaking above two resistance levels, further supporting the bullish outlook for the New Zealand dollar against the U.S. dollar. The main risk to this trade is a broad equity selloff, which could pressure higher-beta currencies like the NZD.