Dollar weakness, but for how long?

The start of 2011 has seen the US dollar loosen its stranglehold over both the pound and the euro. Both currencies are continuing to rally strongly in spite of the fragile economic conditions still seen within both camps.

We have seen gains for the Euro and the pound of around 3% and 4% respectively since the beginning of this year, but how long can this dollar weakness last?

The main driving force behind the movement has been the diverging policy stance seen between the Fed and its counterparts across the Pond.  

The Fed has reiterated its desire to keep interest rates low for an “extended period”, alluding to the fact that, despite some decent economic growth (2.9% in 2010), it will continue to keep monetary policy loose in order to stimulate growth and absorb the chronic levels of unemployment.

By contrast there is speculation that both the ECB and BoE could move to tighten policy (ie raise interest rates) in order to curb inflationary pressures. Such a move is still seen to be some months away, but would doubtless come considerably earlier than in the US, which is bolstering the currencies.

Earlier today, one of the two MPC hawks, Andrew Sentance, suggested that the Bank should act sooner rather than later to retain the Banks' “hard won” credibility by keeping inflation in check, and avoid a sudden and heavier rise of interest rates down the line that would “jolt” the recovery. This policy is beginning to gain further credence, with Sentance sticking to his guns despite recent worries of stagflation.

Similarly, Trichet has recently been hawkish about the prospects of raising interest rates – the market expecting this to come in to effect around September, probably as part of his swansong (his term as ECB President is due to end in October).

With this in mind, coupled with the headlines being oddly devoid of any developments with regards to the eurozone debt crisis, it’s hard to see the dollar reversing its current trend in the short term.

Edward Knox
Analyst
Caxton FX

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