The Dollar During A Recession

The goal of this lesson is for you to apply this to your trading knowledge as well as your macro. By understanding how the dollar is directed during different economic environments, you can place your bias in the dollar (DXY) accordingly too and relate this to the bond yield charts too.

During economic downturns, central banks and governments will usually implement monetary and fiscal policies to stimulate the economy. These measures can include reducing interest rates, increasing government spending, and implementing quantitative easing. Such actions lead to an increase in the money supply and result in the depreciation of the currency.

A prime example of this was during COVID when interest rates were lowered to near zero, making debt more affordable. Furthermore, the FED performed QE, expanding the money supply with the multiple stimulus packages offered to the public playing a major role.

During a recession, investors seek safer assets, usually US Treasury bonds, as they are considered relatively stable compared to other investments. This has a lot to do with the USD being the world reserve currency. This increased demand for Treasury bonds can have a positive impact on the value of the dollar. The low risk that comes with US Treasuries is associated with the creditworthiness of the US government. Because each treasury is backed by the US government, and it is highly unlikely this debt will be defaulted on any time soon. Furthermore, the US Treasury market is the largest and most liquid government bond market globally. This means that there is a deep pool of buyers and sellers for US Treasuries, allowing investors to easily buy or sell their holdings with minimal impact on prices. The liquidity of the market enhances the perceived safety of these bonds. This perception is reinforced by the historical stability of the US government and the relative strength of the US economy compared to others.

As investors seek safer assets during recessionary, turbulent times, this increased demand for US Treasuries creates a higher demand for US dollars, driving up its value in the currency market. This is because investors purchasing US Treasuries will typically need US dollars to make those purchases, leading to an increase in demand for the currency. As the demand for the dollar rises, its value relative to other currencies can strengthen.

When there is an increase in demand for US Treasuries, it generally leads to a decrease in bond yields. Bond yields and prices have an inverse relationship, meaning that when demand for bonds increases, their prices rise, and their yields decrease. The yield represents the return on investment for bondholders. This is calculated by dividing the bond's interest payments by its price.

The result of lower bond yields can have several implications. First, it means that borrowing costs for the government may decrease, as yields on newly issued Treasury bonds are now lower. With this it can also lower borrowing costs for businesses and consumers, potentially encouraging investment and spending, resulting in a rallying market. Secondly, it can impact other interest rates in the economy, as government bond yields serve as benchmarks for various lending rates. Lastly, lower bond yields may incentivise investors to seek higher returns in other investment opportunities, making risk on assets more lucrative. The market therefore, tends to rally in these times, altering market dynamics.