23.07.202108:19 Forex Analysis & Reviews: USD may extend losses despite its recent strong rally

The EUR/USD pair did not change much following the results of the ECB meeting. Traders were waiting with bated breath for this event. Yet, they were disappointed with the dovish stance of the regulator. At first, the euro rose to the high of 1.1813 but later lost all the gains during Christine Lagarde's press conference.

The pair continues to move within the descending channel. If it breaks below the weekly low of 1.1751, it will continue to drop.

Some experts assume that the further movement of the EUR/USD pair will depend not on the ECB's decision and its soft approach to monetary policy in the future but on the trend set by large market players. It is quite possible that the pair will go up. Currently, the economy is quickly recovering after the pandemic and the greenback with its high cost will only spook traders. On the contrary, a cheap dollar may support national producers and reduce the record trade deficit.

Why did the US dollar rally? To start with, it was profitable in the previous months. The US Treasury actively borrowed in the market with the help of large volumes of government bond placements in order to repay bills, reduce debt, and narrow the budget deficit. The cancellation of the national debt ceiling expires at the end of July and there will be no more loans. Consequently, the volume of attracting long-term debt will be equal to the volume of repayment of short-term debt. The US Treasury will manage the budget deficit at the expense of its reserves. According to the latest data, it may last for three months.

July is almost over. Therefore, the Congress will break for its annual recess in August and the first half of September. This is why US lawmakers are unlikely to agree on the ceiling of the national debt. Judging by the progress of negotiations on the reduced infrastructure plan, the debt ceiling issue will not be resolved until the end of October. The US dollar may weaken as the market will receive liquidity from US Treasury reserves in the accounts of the Federal Reserve. Janet Yellen will warn about the risks of a default on the national debt. After that, Congress may again start the discussion of this issue and even reach an agreement.

Now it is important to pay attention to the government bonds yields, which have significantly sunk in recent weeks. During the rally of the US dollar in March, US Treasury yields grew to the level of 1.77%. Market players thought that the growth of the US dollar boosted the growth of US bond yields. Judging by what we see now (the US dollar has risen and government bond yields have collapsed), this assumption is false.

Currently, few people remember the positive correlation between the US dollar and government bond yields because they cannot explain why this is happening. If you go deeper into history, there were many similar situations with the government bond yields and the exchange rate of the US currency.

The fact is that experts very often try to find the reason for what is happening quickly and thus create the illusion that everything is easy and predictable in the market. One event follows after another. In fact, everything is not so simple. If two events occur simultaneously, it does not mean that they are connected with each other. They can be connected but it does not happen all the time. So, sometimes it is better to evaluate the situation from different angles instead of trying to find connections.

Why can low Treasury yields be profitable? There is a hypothesis that if the US dollar starts to fall in the coming months, US Treasury yields will rise as demand for US bonds will decrease. Yields are now at a low level.

This can be explained as follows: in six months, the EUR/USD pair may jump to 1.3000, then 10-year Treasuries yield may rise to 1.8% and higher. If the yields were already at this level, a strong drop in the greenback would push government bonds above the psychological level of 2%. In the US debt market, we would see a massive sell-off. The decrease of the US dollar in such a situation did not take place in any way. Yet, the US Treasury will inject liquidity in the market and the US dollar is sure to decline.