The Dollar's Prospects Are Clouding Over

The dollar's outlook is deteriorating rapidly.

The U.S. Federal Reserve's decision to cut interest rates 50 basis points a week ago may have eased concerns over a global credit crunch and triggered a recovery in risk appetite. However, the move has failed to provide any reassurances on the U.S. economy and the prospects of further rates cuts is keeping the U.S. currency under pressure. "Dollar weakness is likely to remain a theme as narrowing interest rate spreads continue to weigh," said David Simmonds, head of foreign exchange strategy at The Royal Bank of Scotland in London. Steve Barrow, chief currency strategist at Bear Stearns International in London, warns against expecting any early respite either as the dollar is more likely to suffer from bad U.S. economic news than benefit from any positive data as the Fed isn't likely to start hiking rates again at this stage. "This should keep the dollar on a soft note going forward, not just through this week, but over the long haul as well," Barrow said. Of course, some still hold out some hope of an early dollar rebound. Alina Anishchanka, a currency strategist with UBS in London, argued that if Fed Chairman Ben Bernanke convinces the market that the Fed's rate cut wasn't just a preemptive move, but reflected poor economic data that may not be available to the market yet, then the dollar might recover. "We maintain our view that the extent of the weakness in the dollar isn't justified," Anishchanka said. For the moment, though, there is little sign of dollar support emerging with the dollar's trade weighted index falling to a 15-year low of 78.398 and sitting just above its all-time low at 78.19.

Risk Appetite Risen

As credit crunch concerns have faded, risk appetite in general has risen - with investors piling back into high-yielding currencies at the cost of low-yielding ones such as the yen. As a result, not only have commodity currencies such as the Australian, New Zealand and Canadian dollars found renewed strength over the last week, but much more risky emerging market currencies have also come back into vogue. Greg Anderson, a currency strategist with ABN AMRO in Chicago, noted that the MSCI emerging market free local currency equity index has risen to a new record. At the same time, the world market index has recovered 70% of the losses it made when it fell from a record high in July to a new low in August. "The recovery in equities in general matches some relief in credit markets over the last two weeks, where the Fed rate cut and liquidity injections have allowed commercial paper and LIBOR rates to ease," Anderson said. However, the more relaxed market concerns about a global financial crisis aren't being reflected in the dollar. Although lower rates may have helped to reduce the risks of a U.S. recession developing as a result of the country's subprime mortgage problem, there is growing concerns that easier monetary policy will run the risk of encouraging inflation. "Our macro view is that the Fed move has papered over the cracks, with an unfavorable tradeoff between growth and inflation still a major threat to economic and financial market stability," said Steve Pearson, chief currency strategist with Bank of Scotland in London. And new data on the U.S. housing market due later this week, is unlikely to help, said Paul Chertkow, head of global currency research with Bank of Tokyo-Mitsubishi in London. "Data on existing home sales and new home sales later this week are likely to increase concern over the economic outlook," Chertkow said, noting that the dollar is already suffering from the curve in the futures market suggesting that the Fed will engineer two more 25-basis-point rate cuts before the end of the year. "The risk is that the FOMC will be obliged to ease its monetary stance much more substantially," he warned, suggesting that this will keep the dollar sliding against the euro, and even more so against the yen. Early Tuesday in Europe, concern about the U.S. economy continued to dominate market sentiment with the dollar edging down to Y114.70 by 0645 GMT from Y114.91 late Monday in New York, according to EBS. The euro was a little lower, however, at $1.4072 from $1.4084 as a yen rally, driven largely by easing political concerns, pushed the euro down to Y161.40 from Y161.84. The euro isn't being helped by forecasts that the latest Ifo index from Germany later Tuesday will show a decline to 105.0 this month from 105.8 in August.