Why the Dollar is Rallying

April 23, 2008

After hitting a record low against the Euro on Tuesday, there has been little follow through selling in the US dollar, leaving many traders wondering whether this may be a pause before further losses or a potential bottom.

Although I am a long term dollar bear, the break of 1.60 is far from impressive. This indicates that there isn’t much speculative interest in taking the Euro higher in the near term, especially as economic data and official comments start to turn against the Euro and in favor of the US dollar.

Earlier this week we had better than expected US housing market numbers. I would not be surprised to also see a recovery in new home sales. Even though US durable goods will be pressured by the sales of furniture and electronics, Boeing’s incredibly solid end of quarter earnings and their expectations of another strong year suggests that sales of non-defense aircraft could be firm.

As for the Eurozone, we expect German business confidence to deteriorate materially.

Fed fund futures are currently pricing in an 82 percent chance of a quarter point rate cut next week with the remaining 18 percent probability in favor of no rate cut at all. This is a sharp departure from just a week ago when the market was pricing in a 76 percent chance of a 25bp cut and a 24 percent chance of a 50bp cut. The only reason for this dramatic shift in expectations is the increased inflationary pressures.

A week ago, oil prices were trading at $113 a barrel and yesterday it hit an intraday high of $119.90 a barrel.

The dollar should continue to recover for the rest of the week, but the party may end the following week when we have the Federal Reserve interest rate decision and non-farm payrolls due for release. I believe that the market may be under pricing the degree of Fed rate cuts because the problems in the US economy are far from over. Non-farm payrolls should continue to drop while consumer spending will probably slow, leaving the Federal Reserve with a lot of work ahead of them.

Posted in Bernanke, Crude Oil Prices, Fed Rate Cut Expectations, Inflation, US Dollar, euro, euro record high