Dollar Hits Record Low Vs. Euro On Expectations For U.S. Rate Cut

By Simon Kennedy

The dollar marked a new record low against the euro Wednesday amid growing expectations that the Federal Reserve will cut U.S. interest rates next week and fears that the credit crunch is threatening the health of the U.S. economy.

The euro was up 0.5% against the greenback, at $1.3911 -- its highest level since the European currency was launched in 1999.

The dollar has been in decline for the last several sessions amid a growing consensus that the central bank will cut its key federal funds rate. The debate is now centered on whether the Fed will chop a quarter-point or a half-point off its 5.25% at its next policy meeting Sept 18.

"[W]e have high confidence for a 25 basis-point ease next week and see the market finding some equilibrium for that likelihood and in the void of new information from now until then," wrote David Ader, U.S. Government Bond Strategist at RBS Greenwich Capital.

At the same time, the European Central Bank has continued its hawkish commentary. The central bank held interest rates steady at a meeting earlier in September, but Jean-Claude Trichet, the ECB's president, has continued to emphasize anchoring inflationary expectations and said that rate policy was still "accommodative."

The ECB has raised its benchmark rate eight times since late 2005, to 4%.

"The risk assessment in Europe is in transition, though many market participants have yet to completely give up on the idea that the ECB will hike again," wrote analysts at Brown Brothers Harriman & Co.

"We are concerned that the tightening of credit conditions has effectively delivered the tightening that ECB President Trichet had appeared to promise in August," they added.

Japan PM quits

The dollar was slightly down against its Japanese counterpart. It initially strengthened against the yen after Japanese Prime Minister Shinzo Abe announced his resignation, but fell back in European trading as the focus on the currency pair returned to rate expectations.

Abe quit after failing to win popular support in the aftermath of his party's resounding defeat in the July Upper House elections. Abe had reportedly been considering his future after approval ratings didn't recover following the elections.

The dollar was trading at 114.18, up from 113.98 yen in London Wednesday but down from 114.24 yen in late U.S. trading Tuesday.

"When the news of Abe's proposed resignation hit the wires, the knee-jerk reaction was to buy the dollar," Barclays Capital strategists said in a note to clients. "But with reports of Abe's declining popularity heavily populating the media of late, this piece of news is hardly a revelation."

The growing political uncertainty is negative for the yen because it will slow down the economic reform process and will make Bank of Japan Governor Toshiko Fukui less eager to raise rates, but these factors are already accounted for in the market, the Barcap analysts argued.

They added they expect the dollar to fall back below 110 yen by the end of the year as Japanese retail investors become more risk-averse.

Fukui's five-year term expires in March 2008. Under his stewardship, the central bank lifted its quantitative monetary easing in March 2006 and then ended its zero-rate policy in July of that year.

At its last monthly meeting, the BOJ held its key interest rate steady at 0.5%, despite what some analysts had interpreted as signs the central bank was preparing for a hike.

Japan's low interest rates have kept its currency weak by inviting carry trades, in which investors borrowed funds in yen at low rates to invest in other higher-yielding assets. As recently as June, the dollar was trading at 124 yen, but dropped when investors started paying back their yen borrowings as yen appreciation threatened to erode their returns.

The stronger yen weighs on the Japanese economy by making Japanese overseas earnings worth less when repatriated into yen.