US Dollar May Rally Despite Worsening Fed Rate Forecasts

The US dollar took an early tumble on marginally disappointing Consumer Price Index and Housing Starts data, but later Dow Jones Industrial Average tumbles allowed the greenback to regain ground on risk aversion in broader financial markets. Previously billed as the event of the week, a largely uneventful CPI result gave little reason to shift outlook on the future of domestic interest rates.

The Euro initially scaled heights of $1.4211 through early New York trade, but a later Dow sell-off forced a notable reversal mid-way through the session. Relatively bullish economic developments out of the UK allowed the British Pound to set similar intraday heights against the dollar, but the Sterling later fell on the turn in stock market performance. The Japanese Yen was the largest gainer among major currencies, as a carry trade tumble forced similar drops across all JPY crosses.
Morning Consumer Price Index data fell largely in line with consensus forecasts, easing fears that strong price pressures would keep the US Federal Reserve from cutting interest rates further in 2007. A worsened outlook on US dollar interest rate differentials instantly forced the greenback lower, as markets now price in a 54 percent probability that the Federal Reserve will cut interest rates to 4.50 percent through its October meeting. This represents a significant shift from one week ago, when Federal Funds Futures priced in just a 36 percent chance of such on occurrence. All else remaining equal, the sudden change in sentiment could send the US dollar substantively lower against major forex counterparts. Yet continued risk aversion and the threat of strong currency volatility following the weekend’s G7 summit may keep the dollar relatively bid through short term trade.
US stock markets continue to play a large role in currency trading, as a sudden reversal in the Dow Jones Industrial Average forced speculators to cover overextended US dollar and Japanese Yen short positions. The Dow initially saw itself substantively higher on the open, but a subsequent sell-off left the key index 0.6 percent down to 13,836 just two hours ahead of the close. The only major index to remain higher on the day was the NASDAQ Composite, adding 0.3 percent to 2,771. Yet strength in the technology sector was not enough to leave the highly diversified S&P 500 improved, as it lost 5 points to 1,533 at time of writing.
Renewed risk aversion forced the second day of substantial rallies in US Treasury Bonds, and the yield on the 2-Year Note tumbled 11 basis points to 3.99 percent. The aforementioned shift in interest rate expectations undoubtedly played a role in the sudden bond volatility, but it is clear that market skittishness drove the majority of Treasury price advances. The longer-dated 10-year yield tumbled a similar 10bp to 4.55 percent.
Written by David RodrĂ­guez, Currency Analyst for