Dollar May Beat Euro as Inflation Focus Trumps Subprime Rout

By Lukanyo Mnyanda and Ye Xie

June 16 (Bloomberg) -- Currency forecasters are betting that the dollar rally is just getting started as the Federal Reserve's shift to fighting inflation makes it likely to raise interest rates more aggressively than the European Central Bank.

The currency will strengthen 2.5 percent to $1.50 per euro by year-end, according to the mean estimate of 39 firms surveyed by Bloomberg. Economists anticipate that the ECB will raise rates a quarter-percentage point by September and then cut borrowing costs by yearend. Fed Chairman Ben S. Bernanke, who said he's ``attentive'' to the U.S. currency, will boost rates three-quarters of a percentage point by the end of the third quarter of 2009, according to data compiled by Bloomberg.

``We've seen a very significant shift in Fed emphasis; they're now clearly focused on inflation and the need to control inflation expectations,'' said Ian Stannard, senior foreign- exchange strategist in London at BNP Paribas SA, the most accurate currency forecaster in a 2007 Bloomberg survey. ``We're likely to see the currency recover some ground.''

U.S. consumer prices rose 0.6 percent in May, the most since November and faster than forecast, the Labor Department said June 13. The report reinforced expectations the Fed will raise rates to 2.75 percent in the next 15 months from the current 2 percent.

The dollar had its biggest weekly gain in three years against the European and Japanese currencies. It strengthened 3.1 percent versus the yen to 108.19 and 2.5 percent against the euro to $1.5380.

Dollar, Stocks, Bonds

Concern about inflation also sent U.S. two-year notes to their steepest weekly loss in more than six years. The Standard & Poor's 500 Index, the benchmark for U.S. equities, dropped for a second straight week. Not since the week ending Feb. 8 has the dollar gained while Treasuries and the S&P 500 fell.

Options traders reversed bets in favor of the euro. A week ago, demand for options granting the right to buy the euro exceeded those offering the right to sell for the first time this year.

The so-called risk-reversal rate changed as traders speculated Group of Eight officials would signal they favor a stronger dollar and French Finance Minister Christine Lagarde described the U.S. currency's gains as ``very satisfying.''

``Verbal intervention has become more powerful,'' said Daniel Janis, who helps manage the $2 billion John Hancock Strategic Income Fund in Boston. ``You are likely to see a more stable dollar.''

Bear Stearns Rescue

The dollar index, which measures the U.S. currency against six trading partners, tumbled almost 9 percent between Sept. 18 and April 22 as the Fed cut its target rate for overnight bank loans by a total 3 percentage points to stave off a recession caused by tumbling home prices and a seizure in credit markets sparked by losses in subprime-related securities.

It rebounded 4 percent since then after the Fed helped arrange the bailout of Bear Stearns Cos. by JPMorgan Chase & Co. and investors shifted their focus to inflation instead of the credit crunch.

G-8 finance ministers said the credit squeeze has been replaced by surging food and fuel prices as the biggest threat to the world economy.

``The predominant concern is the inflationary effect that oil in particular and also food prices are having,'' U.K. Chancellor of the Exchequer Alistair Darling said June 14 after the talks ended in Osaka, Japan. Deputy German Finance Minister Thomas Mirow said oil's rise to a record means ``an enormous withdrawal of purchasing power.''

Oil reached $139.12 a barrel on June 6 and corn futures for December delivery rose 0.5 cent to $7.40 a bushel on the Chicago Board of Trade.

Price Stability

The Fed's commitment to price stability and maximum employment ``will be key factors ensuring that the dollar remains a strong and stable currency,'' Bernanke said June 3.

The remarks were a ``change of rhetoric'' that showed the dollar ``has bottomed,'' said Stephen Jen, chief currency economist at Morgan Stanley in London, who used to work at the Fed.

``Central banks are trying to get ahead of the curve by tightening faster than the market has been imagining.'' said Tim Bond, head of global asset allocation at Barclays Capital in London. The Fed will lift its target rate for overnight bank loans a quarter point in September and October, Barclays said in a report June 13. Higher interest rates support a country's currency by making its fixed-income assets more attractive.

Bulls in Minority

Dollar bulls are still in the minority, in part because ECB President Jean-Claude Trichet has also said inflation is a concern and the ECB rate is double the Fed's.

UBS AG, the second-biggest currency trader, last week cut its one- and three-month dollar forecasts against the euro to $1.60 and $1.53, from estimates of $1.50 and $1.47, respectively. Citigroup Global Markets Inc. reversed its bet on dollar gains, expecting the currency to fall to $1.63 within two months.

The dollar will trade at $1.50 to the euro and 105 yen by the end of the year, according to analysts in a Bloomberg survey.

``Actions speak louder than words,'' said Adam Boyton, a senior currency strategist in New York at Deutsche Bank AG, the world's biggest currency trader, according to Euromoney Institutional Investor Plc. He forecast the euro will trade between $1.50 and $1.60 in the next three months. The Fed's still ``some way away from actually being ready to pull the trigger,'' he said.

Stretched Strength

Technical indictors show the dollar's strength may be stretched. So-called trading envelopes, which measure how far from the mean a price has strayed, showed the dollar gained more than two-standard deviations in the past three weeks. The last time the indicator reached that level on May 8, the dollar lost 3 percent in two weeks.

Institutional investors bought more dollars than they sold this year, according to State Street Corp. and Bank of New York Mellon Corp., the largest money managers for institutions.

The dollar gained in 71 percent of the quarters over the past decade when they were net buyers, according to Boston-based State Street. The biggest investors bought more than they sold in all of the quarters when, like now, benchmark interest rates were below inflation and the current account deficit, the broadest measure of trade, exceeded 3 percent of the economy.

``There's much more scope for interest rates in the U.S. to get a lot higher,'' said Andrew Wilkinson, a senior market analyst at Greenwich, Connecticut-based Interactive Brokers Group Inc., which handles a fifth of all options traded in the U.S. ``We've put a floor under the dollar. I'll bet my money on the dollar rally.''

To contact the reporters on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net; Ye Xie in New York at yxie6@bloomberg.net
Last Updated: June 15, 2008 12:41 EDT

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