US Dollar Hits Record Lows, Will it Continue to Fall?

March 5, 2008

What’s Driving the US Dollar Lower?

Oh why oh why oh why….is the US dollar getting killed? The dollar hit a new all time record low against the Euro this morning as fear and gloom sets across both Wall Street and Main Street. Activity in the service and manufacturing sectors are contracting, leading everyone to believe that not only will we see another month of job losses, but we will also see a contraction in retail sales. Yes, gas receipts and food prices are rising which could increase the absolute value of purchases, but this does not take away from the fact that this trend hurts and not helps the US economy. Earlier this week, Warren Buffet proclaimed that the US economy is already in a recession. I think that a recession or no recession is just a matter of semantics at this point. The Federal Reserve seems to agree, which is why last week, Fed President Ben Bernanke basically told the markets that they will be putting 100% of their focus on growth. According to Fed fund futures, the choice for the Fed at this month’s monetary policy meeting is between cutting interest rates by 50 or 75bp.

Will it Continue to Fall?

Yes. There is a decent chance at this point that we may see 1.50 to 1.00 percent interest rates. The Federal Reserve is behind the curve. Two year bonds are yielding 1.678 percent while Fed Fund rates are 3.00 percent. That’s a difference of over 130bp. Since 1990, the average spread between the 2 year treasury rates and Fed funds is approximately +50bp and over the past 10 years, it is +25bp. Therefore it is not rocket science to see that a gap of -130bp is a huge discrepancy. In order for the gap to be neutral, the Fed would need to immediately cut interest rates by 125bp. In order for it to revert back to the 10 year average, rates would need to come down 150bp, putting the Fed Funds rate at 1.50 percent. This is why I think interest rates will continue to fall and the US dollar will come down with it. BUT with that in mind, I still do think that the US dollar will recover in the second half of the year.

I’m looking at 1.55 in the EUR/USD and 100 in USD/JPY.

Posted in US Economy, US Treasuries, US Dollar