Forex

Another 75bp is probably the best that we will get from the U.S. Central Bank because at some point, they will no longer be able to turn a blind eye to inflation. According to the March 18 FOMC minutes, two of the Fed Presidents expressed strong concern about heightened inflation risks and favored easing policy less aggressively than the 75bp that the Fed actually delivered. They believe that it takes time for rate cuts to be felt in the economy and that they cannot wait for evidence of inflation sticking, as by then it would be too late to prevent a further increase.
Interest rate cuts alone will not do the trick; and for this reason, the Federal Reserve needs to focus on other measures targeted at relieving liquidity strains. Slowing down or putting an end to rate cuts may be exactly what the U.S. dollar needs to recover. Going forward, we expect more creativity from the Federal Reserve because, short of printing money, the size of the Federal Reserve’s balance sheet will limit what they can do. In the middle of March, the Fed committed to swap 60% ($420 billion) of its $700 billion balance sheet of U.S. Treasuries for mortgage-backed securities. Recently, there have been reports that the Fed is eyeing the Nordic-style nationalization of U.S. banks as a temporary solution to the U.S. financial crisis. Printing money in the current market environment is not a likely option because it would foster even stronger inflationary pressures.
The second factor that could turn the dollar around would be a sharp slowdown in the euro zone economy. This is discussed further in the Q2 outlook for the euro zone, but recoupling in the fourth quarter of 2008 could play a big role in the dollar’s recovery. The ripple effects of the U.S. subprime crisis have affected many countries, and chinks in the armor are beginning to show in the euro zone despite the European Central Bank's persistently hawkish monetary policy stance. Eventually, the ECB will be forced to cut interest rates, and at that time, they will most likely find themselves behind the curve. This will result in an interesting twist of fate where the ECB begins to cut interest rates at a time when the Federal Reserve is done.