US Treasury Secretary Scott Bessent has warned that the effects of the US federal shutdown are worsening the economy. However, there is some good news: we are seeing progress in reducing inflation, and price drops are expected in the upcoming months. As of the latest report, the US Dollar Index (DXY) rose by 0.15% to 99.70. The US Dollar, the most traded currency globally, made up more than 88% of all foreign exchange transactions, averaging $6.6 trillion each day in 2022.

Influence of Monetary Policy

Monetary policy set by the Federal Reserve (Fed) plays a significant role in determining the value of the US Dollar. The Fed changes interest rates to manage inflation and keep employment steady. When rates go up, the USD strengthens. Conversely, rate cuts can weaken it. In severe situations, the Fed may use quantitative easing (QE), which adds more dollars to the economy by buying US bonds. This usually weakens the dollar. On the other hand, quantitative tightening (QT) happens when the Fed stops buying bonds, which can boost the dollar’s strength. Treasury Secretary Bessent’s warning about the federal shutdown gives us a picture of a weakening economy. Yet, the US Dollar Index has surprisingly risen to 99.70, creating a tricky situation as we move forward. We’ve faced similar disruptions before. The 35-day shutdown from late 2018 to early 2019 cut 0.2% off real GDP in the first quarter of 2019, according to the Congressional Budget Office. If the current shutdown continues, we could see a similar or greater impact on economic data, which typically weakens a currency.

Opportunities in Market Uncertainty

The dollar’s current strength may be a short-term reaction to global uncertainty, prompting investors to flock to US assets. However, the underlying economic damage and expected drops in inflation suggest a weaker dollar over time. This clash between immediate fears and long-term trends presents potential opportunities. In light of this uncertainty, we should think about strategies that can benefit from increased market volatility. The VIX index, which measures market fear, has risen to 18.5, a notable increase from last month’s low of 14. Purchasing options like straddles or strangles on major currency pairs such as EUR/USD can allow us to profit from significant price movements in either direction. We also need to monitor interest rate derivatives closely. A prolonged shutdown raises the chances of a recession and puts pressure on the Federal Reserve to lower rates. The Fed Funds futures market is now suggesting a 40% chance of a rate cut by the end of the first quarter in 2026, up from 15% two weeks ago. Positioning for lower rates through these financial tools could be a smart move given the growing economic challenges. Once the initial rush to safety calms down, the dollar’s fundamentals will likely come back into play. We can prepare for this by using options to hedge against dollar weakness while managing our risk. For instance, buying put options on a dollar-tracking ETF allows us to sell at a higher price if the dollar’s value falls due to negative economic news. Create your live VT Markets account and start trading now.

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