Speculation about a dollar rally is building as interest rates “bottom” and the economy “begins to recover.” Brown Brothers thinks the optimism is premature.
Brown Brothers says the dollar isn’t yet ready to take off, despite more favourable interest rate differentials. BB believes the dollar has four distinct phases of movement against the Euro:
1. weak dollar while interest rate differentials move against the US (the case in recent quarters).
2. the dollar may remain weak as interest rate differentials begin moving in its favour.
3. The dollar could strengthen as interest rate differentials continue to move in its favour,
4. later, the dollar could strengthen when interest rate differentials begin moving against the US.
So which phase are we in now, and which phase are we moving into? According to Brown Brothers we are currently in Phase IV (where rate differentials are unfavorable and the dollar is weak) and moving towards Phase I (where rate differentials are more favourable but the dollar remains weak):
As the spread between Euribor and Eurodollar Futures contracts (a proxy for US-EU rate differentials) narrows, however, there’s every indication that the environment is turning pro-dollar. This suggests that we’ve exited Phase 4, and that the dollar has finally bottomed.
The US dollar bottomed against half of the non-US G7 currencies, sterling and the Canadian dollar, last November. The dollar’s location in its super-cycle does not preclude a marginal new low against the euro. It does support our view, however, that the dollar’s multi-year downtrend is nearing an end.
So while we may have reached bottom, this doesn’t mean that a rally is neccesarily forthcoming. As the Eurozone holds on rate cuts and grapples with inflation, softness is likely to continue. Until a real recovery in the U.S. economy begins in earnest and inflation settles down in Europe, allowing rate cuts, the dollar seems likely to hover in limbo. But at least Brown Brothers thinks we’re finally reaching the bottom.
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