Can the US Dollar Continue to Rally Even if the US Economy Slows?

August 29, 2008

The US dollar has been quietly trended higher since the European trading session.The EUR/USD hit a high of 1.4768 shortly after the London open but ended the US session near its daily lows.Although this strength was also seen against many of the other major currencies, the dollar failed to rally against the Japanese Yen.This weakness was primarily due to the move in US equities which dropped over 170 points in the US session.Oil also reversed sharply, ending the day slightly under $116 a barrel, after having hit an intraday high of 118.76.

August has been a very good month for the dollar with the currency seeing its strongest 1 month rally in more than 15 years.Although the US economy remains weak, the price action in the dollar indicates that the currency can rally even if the economy slows.Trading the currency market is oftentimes an expectations game.Since July, the market’s expectations for growth have shifted dramatically.Over the past month, it has become increasingly clear that traders have underestimated US growth and overestimated growth outside of the US.GDP growth in the second quarter was 3.3 percent, far above everyone’s estimates.Since April, the trade deficit has also narrowed, adding fuel to the dollar’s rally.Looking ahead, the question is can the dollar’s rally continue?The answer is a qualified yes.The rally can continue but certainly not at the pace that we have seen over the past month.Four central banks are meeting to decide on monetary policy next week, one of which is expected to lower interest rates. Don’t expect this central bank to be the last.The Federal Reserve has already done its work and rates are low enough that they will not be decreased again in this monetary policy cycle.Everyone else on the other with the exception of the Bank of Japan still have plenty of room to cut rates.

The dollar’s weakness in the first half of the year helped to support corporate earnings and M&A flow.The recovery in the dollar since then strips away the foreign exchange contributions which could have a negative impact on earnings in the remainder of the year. The US data released this morning was mixed with personal spending rising slightly but personal income dropping by 0.7 percent.The Chicago PMI and University of Michigan consumer confidence numbers were both better than expected.

The US markets are closed on Monday for Labor Day (there will be no commentary), but the shortened trading week only means a busier one.Service and manufacturing ISM are due for release along with the Fed’s Beige Book report and non-farm payrolls.The US economy is expected to see its eighth consecutive month of negative job growth.

Expectations for the 9/16 Fed Meeting