Which Currencies Will Do Best Against the US Dollar?

03/20/2009 10:15 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

For regular readers of MoneyShow.com, it should be no surprise that the dollar has continued to weaken. On Wednesday, we said that the actions by the Federal Reserve have cemented the downtrend in the US dollar. Given how currency traders have responded to previous quantitative easing threats and announcements, the EUR/USD could realistically hit 1.40 (see charts). Although equities have given back their gains and bond yields have rallied, the moves in the currency and commodity markets indicate that the Fed’s actions will have a lasting impact on the financial markets. As we look forward to more dollar weakness, it is worthwhile to consider how a weaker dollar impacts the global economy.

Global Ramifications of Dollar Weakness

As the most actively transacted currency in the world, the fluctuations in the US dollar have broad ramifications for the global economy. Most obviously, the weakness of the greenback drives other currencies such as the euro, British pound, and Japanese yen higher. For those countries, a significant rally in their currency has a similar affect on the economy as rate hike. Many commodities are also priced in dollars, which explains why oil and gold prices are dramatically higher. Oil prices peaked in July 2008, at the exact same time that the US dollar bottomed. Since July 2008, the price of oil has had a 90% negative correlation with the dollar index, which roughly means that when the dollar rises, oil prices fall 90% of the time. Higher commodity prices and a weaker dollar will drive inflation higher, but for the time being, this is not a concern for the Fed because weak demand will prevent vendors from raising prices. Finally, the weaker dollar will help US companies selling goods abroad by either increasing the competitiveness of US exports or increasing the value of foreign earnings when converted by into US dollars.

Which Currencies Will Do Best Against the US Dollar?

The currencies that will do best against the US dollar are those with central banks that are not eager to follow in the footsteps of the Federal Reserve, the Bank of England, and the Bank of Japan. These include the European Central Bank, Reserve Bank of Australia, and the Reserve Bank of New Zealand. All three of these central banks have interest rates above 1.00% and have been slow to cut interest rates, let alone embark on quantitative easing. The parabolic moves over the past 24 hours will inevitably lead to a correction, but in general, we expect further gains in the EUR/USD, AUD/USD, and NZD/USD.

The EUR/USD has now rallied for eight consecutive trading days. We believe that the currency pair will hit 1.40, but it is important to mention that 1.3850 is a significant resistance level. Fundamentally, the European Central Bank continues to give us reasons to be bullish on the euro. Although they have suggested that interest rates will fall below current levels, they are also quick to point out that interest rates are already very low and they stand ready to reverse their rate cuts if inflation accelerates once again. Comments such as these are not reflective of a central bank that is willing to “do all that they can” to stabilize the euro zone economy.

Unfortunately, by being frugal with their monetary stimulus over the past few months, their efforts will be set back even further by the strength of the euro. Meanwhile, we are also keeping an eye on the Swiss franc. After intervening to sell francs earlier this month, the Swiss National Bank has returned with more threats. This afternoon, SNB member Jordan said that the central bank will not tolerate further franc appreciation and the market realized immediately after their intervention that the SNB is serious. They will now be monitoring the FX markets permanently and will be intervening according to the situation in the currency. However, what was most surprising was his comment that the SNB could impose negative rates on deposits. This would be an extremely nuclear action by the SNB, but not the first time they have resorted to this option. In the 1970s, Switzerland offered negative interests to discourage foreigners to hold Swiss francs. Investors should take note that the SNB is very serious about capping the rise in the Swiss franc because the economy has weakened dramatically. Switzerland’s unemployment rate hit a three-year high of 8% last month while the trade surplus shrank from 1.99B to 0.73B.

The Currency in Play for the Next 24 Hours

The currency in play for the next 24 hours will be the EUR/USD. German producer prices will be released around 7:00 GMT (3:00 am EST), while euro zone industrial production figures are anticipated at 10:00GMT (6:00 am EST). After eight consecutive days of advances, the EUR/USD pair is trading within the buy zone established using the Bollinger bands. The 61.8% of December highs and this year’s lows represents resistance at 1.3850. Support, on the other hand, is set at the low for today’s session and second standard deviation of the Bollinger bands between 1.3385 and 1.3415.

By Kathy Lien, Director of Currency Research at GFTForex.com

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