Fed looks powerless to halt dollar's slide

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By Steven C. Johnson
Reuters
Friday, December 1, 2006

http://today.reuters.com/news/articleinvesting.aspx?type=hotStocksNews&s...

NEW YORK -- The dollar tumbled against major currencies on Friday en route to a second week of losses, and this time it's going to take more than Federal Reserve warnings about inflation to stop the slide.

U.S. manufacturing output shrank in November for the first time in 3 1/2 years, according to data from the Institute of Supply Management on Friday, stoking fears that the slowing U.S. economy may be headed for recession.

"The data is starting to drive home the point that the Fed, despite its concerns about inflation, will have to cut rates next year," said Greg Salvaggio, vice president of trading at Tempus Consulting in Washington, D.C.

Making matters worse for the dollar, recent economic data from the euro zone, particularly Germany and France, has showed robust growth, and suported the case for the European Central Bank to lift interest rates to 3.5 percent this month.

Analysts say that clears a path for the euro, which surged above $1.33 for the first time in almost two years on Friday, to hit $1.35 in the coming sessions, and possibly test its December 2004 record high above $1.36.

"The floodgates are open, and for lack of a better metaphor, the rats are jumping off the ship," Salvaggio said, adding that a euro at $1.35 and sterling at $2, a level it hasn't hit since 1992, are within reach by early next week.

The U.S. economic growth rate for the third quarter was revised up to 2.2 percent from 1.6 percent this week by the U.S. Commerce Department.

But both the White House and the Organization for Economic Cooperation and Development downgraded their forecasts for U.S. full-year growth in 2006 and 2007, citing a weakening housing market.

Fed officials, though, have continued to warn about lingering inflation risks, implying the possibility of higher short term interest rates.

Chicago Fed President Michael Moskow on Friday was the latest to reiterate that rates may still have to rise to ward off higher inflation.

But perhaps for the first time since mid-2004, when the Fed began its campaign to raise interest rates, markets are not listening.

"The Fed is being shrugged off by the markets," said Firas Askari, head of trading at BMO Capital Markets in Toronto, adding that it will take "a monetary policy shift from Europe to turn dollar weakness around."

Instead, traders are increasing their bets that the Fed will cut interest rates early next year, perhaps with good reason.

Brian Garvey, strategist at State Street Global Markets in Boston, noted that in the past, the Fed has typically eased monetary policy about three to four months after the Institute for Supply Management's manufacturing index dropped below 50, the threshhold for a contraction, as it did Friday for the first time since 2003.

Andrew Busch, BMO's senior currency strategist in Chicago, said for now, that looks unlikely.

"The recent strength in Europe sets up a situation where we have a very strong contrast between the two economies right now," he said.

Of course, a rebound in the dollar of some sort is likely at some point, analysts said. While predicting a short-term euro move to $1.35, Deutsche Bank strategists cite the dollar's tendency to rally in January each year as reason to take profits in early 2007.

Also, European officials worried about a strong euro's impact on exports may ratchet up verbal intervention should the currency rises to the $1.40 area, though so far most have sounded sanguine about the moves so far.

Divyang Shah, strategist at IDEAglobal, said that for now it looks like officials around the world are signing off on the dollar's decline in hopes it shrinks the U.S. current account deficit and blunts protectionist pressure that may build up as the U.S. economy slows.

It all adds up to a strong bout of dollar-malaise that should prove difficult to shake, said Omer Esiner, senior market analyst at Ruesch International in Washington, D.C.

"Buying dollars is a hard case to make right now," he said.

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