Don’t Bank on a US Dollar Bottom

04/19/2011 6:00 am EST

Focus: FOREX

Kathy Lien

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

Signs are emerging that the battered US dollar may begin to strengthen, but don’t jump on the bandwagon just yet, warns one trader, citing a host of weak fundamental factors.

Since the beginning of the year, the US dollar has weakened significantly. It lost more than 7% of its value against the euro, more than 4% against the Swiss franc and British pound, and more than 3% against the Australian dollar.

The downtrend in the dollar has been so strong that investors have practically grown accustomed to dollar weakness.

Over the past week however, the selloff in the dollar lost its momentum with currency pairs such as the EUR/USD consolidating below 1.45 and the GBP/USD below 1.64.

During periods such as these, it is tempting to speculate on the possibility of a bottom in the greenback and a top in high-yielding currencies.

But before rushing to pass judgment, it is important to realize that the dollar remains weak and has continued to sell off against the Japanese yen and Australian and New Zealand dollars. In fact, USD weakness drove the NZD to its highest level in more than three years.

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Aside from the fact that the dollar has fallen significantly over a very short period of time, there is little fundamental reason for investors to buy dollars.

Fed Is in No Hurry to Raise Rates

The US economy is improving, but the latest economic reports give the Fed little reason to act, and the US central bank’s lax attitude towards normalizing monetary policy is the main reason for the dollar’s weakness.

With the Federal Open Market Committee (FOMC) meeting less than two weeks away, we do not expect Fed officials to say anything particularly positive for the dollar.

Many central bank officials have spoken over the past week, and their message is clear: They believe in the US recovery, but with muted inflationary pressures in the US, they are in no rush to raise interest rates. As a result, it is more likely that the dollar’s current support level will be a pause, rather than a bottom.

Yesterday’s US economic reports showed that despite the rise in food and energy costs, inflation may be a problem for many countries, but not for the US. Consumer prices rose 0.5% in March, which was right in line with expectations.

Core price growth, on the other hand, slowed to 0.1% from 0.2% the previous month. On an annualized basis, CPI edged higher, but for the time being, producers only have the ability to pass through part of their costs as weak demand prevents any meaningful price increases.

Manufacturing activity, on the other hand, remains strong with the Empire State manufacturing survey rising to its highest level in a year. The details of the report were even stronger than the headline number, with prices paid rising to the highest level since August 2008 and the employment index rising to its highest since May 2004.

Industrial production also increased 0.8% with capacity utilization rising from 76.9% to 77.4%. The manufacturing sector has been one of the biggest beneficiaries of a weak dollar and stronger global demand.

Yet even the continued strength in manufacturing will not convince the Federal Reserve to raise interest rates prematurely. Fed president Plosser doesn't see the need for additional quantitative easing, and he said that it is "not inconceivable" for interest rates to be increased this year, but the US economy needs to improve for a rate hike to be warranted.

If one of the most hawkish members of the FOMC is hesitant about tightening monetary policy, there is a good chance that the US central bank will be one of the last to raise interest rates.

At the end of the day, this may turn out like the story of the tortoise and the hare. The longer the US leaves monetary policy easy, the more underlying support it will provide to the US economy. It may keep the weak dollar, but a weak currency supports the recovery.

In contrast, a strong currency and higher interest rates in the euro zone could hurt growth in that region.  

The focus this week will be on housing with the NAHB housing market index scheduled for release, along with housing starts, building permits, existing home sales, and the house price index. 

February was a terrible month for starts, permits, and home sales, and as a result, a rebound is expected in March.

Aside from these housing market reports, jobless claims, leading indicators, and the Philadelphia Fed survey are also due for release.

By Kathy Lien of KathyLien.com

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