How Could the Dollar Trade in 2010?

Last updated 1/1/2010 9:42 AM ET (GMT -5) 8 Comments

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Kathy Lien

Director of Currency Research, GFT

It is officially a New Year, a New Decade and we want to wish everyone the greatest success! As we look forward to 2010, many people may be wondering if the dollar will continue to strengthen. Before attempting to address this question, it is important to recognize that much of the weakness in the U.S. dollar over the past year has been triggered by the Federal Reserve lowering interest rates to record lows. The primary reason for the latest strength in the dollar is also rooted in the belief that the U.S. recovery is accelerating and therefore the Fed could implement their exit strategies and raise interest rates earlier than previously anticipated. Based upon Fed fund futures, the market is currently pricing in a rate hike by the U.S. central bank in the second half of the year. There is currently a 57 percent chance of a rate hike at the June meeting followed by an 80 percent chance of a hike in August.

*As of 12/30/09

When it comes to forecasting where currencies are headed, the number one driver is always interest rates. This catalyst will be particularly important in 2010 when everyone will be focusing in exit strategies and rate hikes.

Therefore we thought it would be interesting to examine how the dollar trades before and after Fed tightening. In order to gather this data, we looked at the Fed’s tightening cycle only after a prolonged period of easing or steady monetary policy. We examined 8 periods of tightening over the past 3 decades and compared how the EUR/USD and USD/JPY traded before and after the Federal Reserve began to raise interest rates. To help understand these tables, in 2004 for example, 3 months before the Fed began to tighten, the EUR/USD was trading 2 percent lower. In other words, it appreciated 2 percent ahead of the rate hike. Three months after the Fed actually tightened, the EUR/USD was trading 1 percent higher which means that after the rate hike, the dollar actually weakened against the euro.

EUR/USD,

EUR/USD

10 Year Change in the Major Currency Pairs

More interesting information! Between 2000 and 2009, Americans have watched their wealth and global purchasing power slip away. The last decade has not been kind to the U.S. dollar, which depreciated against every major currency except for the British pound. The dollar’s weakness can be attributed to growing deficits, the decreasing importance of the U.S. dollar as a reserve currency and the global financial crisis. Hopefully we won’t be walking into another 10 years of dollar weakness! Finally, if you haven’t done so already, we encourage you to read our article on the Top 5 Forex Events of the Past Decade . Happy New Year!

Comments (8)

gabri558

January 01, 2010 at 11:29 AM ET

Happy New Year 2 u Kathy n' 2 all e guys @ FX360!!

vg5157

January 01, 2010 at 12:50 PM ET

So,according to Kathy ,higher interest rates ,better for dollars trading ?

MTkach

January 02, 2010 at 10:05 PM ET

Hi Vg5157,

The way I understood is that it is not, at least initially. But I could be wrong so I would be happy if Kathy could confirm.

MTkach

January 02, 2010 at 10:03 PM ET

So if I understand correctly, you observe from your research that raising US interest leads to weaker USD. One reason you gave is that growth in US is good for JP exports --> stronger JPY against USD. Here is my thought that I wish you to critically assess and comment on.

I assume that bulk of foreign capital inflows into US ends up as investment in US Equity Markets. Higher US rates will hurt stocks and lead to some some such investments liquidation and withdrawal of foreign capital flows resulting in weaker USD.

schultzz.at

January 04, 2010 at 04:51 AM ET

In fact the bulk of foreign capital inflows ended up in Treasury Securities and Government Agency Bonds according to the Treasury Department's TIC data. Since 1978 it shows cumulated inflows into Treasuries at 3.1 trillion, Agency Bonds 2 trillion, Corporate Bonds 3.3 trillion, Equities 1.3 trillion. Interestingly, U.S. residents sold foreign equities worth 950 billion during that period.
These flows do not seem to be reliably correlated with the foreign exchange value of the USD. However, these numbers are correlated with the U.S. current account deficit, as foreigners channel their surplus dollars back to the U.S.

The correlation between short term rates and the stock market is also not so obvious. Remember that the Dow peaked in October 2007 while the funds rate was already on the way down.
The panic of 2008 demonstrated that the USD and Treasuries are still the ultimate save haven investments. In 2009 massive government intervention restored investor confidence with equities, junk bonds, commodities and other risk assets up.
My personal feeling is that the crowd was overly optimistic on risk assets and overly pessimistic on the relative strength of the USD.

As far as the USD is concerned sentiment has reversed. We are now playing the 'Fed hike scenario'. Fed Governor Kohn said in yesterday's speech that the Fed 'will need to begin withdrawing extraordinary monetary stimulus well before the economy returns to high levels of resource utilization'.
The USD will be particularly well bid against the European and Japanese currencies as these economies face a daunting malaise. Currently, I see no way for Greece to escape some sort of debt restructuring and Spain will face a collapse in house prices and banks which have real estate on their books. Japan's real GDP is back at 1991 levels.
My forecast is for a 7% surge of the trade weighted dollar index to 83.5 from its current level of 78 in the first quarter of 2010. The move would be comparable to the first quarter of 1997.

Oded

January 03, 2010 at 06:42 AM ET

In my view there is no doubt about the direction of the USD in the next 6 month.
5 week ago i wrote to many that the USD is about to get very stronger dramaticky. It did.
How ever now we should look only for correction and again the USD shall go up.
USD CAD - very interesting pair- again - only correction and strongly up

I do hope to see the EURUSD go up this week or maybe even next week- after a very long short trade.
This is my opinion. for the next couple month- the USD we be strong again and more.
Good luck
www.elbariasiognals.com

suavingbest

January 03, 2010 at 10:49 AM ET

Yes,I think the USD/CAD will be up next months since the Canadian exports is fall and the the oil prices seems to be down after January 15...

klien

January 03, 2010 at 02:19 PM ET

MTKach > your comments are valid. Although there are many reasons why the dollar could continue to weaken, the possibility of dollar weakness against the yen once the Fed starts raising rates is a statistical observation. Also, this is AFTER the Fed begins to raise rates which is not expected until June-Aug. Before the rate hike (which is where we are now) there is a mild bias for dollar strength against the euro. The closest comparison of the current recession with previous ones that we looked at is the 70s and 80s so I would put more weight on that data.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.