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Dollar party may be over soon
The currency has made surprising gains this year but rate moves in Europe could change all that.
November 8, 2005: 3:27 PM EST
By Grace Wong, CNN/Money staff writer
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NEW YORK (CNN/Money) - The dollar is showing another round of surprising strength but some currency analysts are saying that the party's probably almost over.

That's because the European Central Bank looks like it's getting ready to start making its first short-term interest rate hikes in five years -- a move likely to help the troubled euro and put pressure on the soaring dollar.

The dollar has made some heady gains this year. It's up about 13 percent against the euro and 14 percent against the Japanese yen, according to Reuters. It hit a two-year high against the euro Tuesday, with the European currency sinking as low as $1.1711, pressured by interest rates as well as worries about unrest in France.

Still, there's reason to pay attention to the message central bankers across the Atlantic are sending, as a stronger dollar has made traveling abroad and buying foreign products cheaper for Americans this year. (Full story.)

But if the dollar rally is nearing an end, and if you've been waiting, it may be time to start packing for that European vacation .

Mind the gap

Fueling the greenback's rise this year has been the string of interest rate hikes by the Federal Reserve. In a bid to keep inflation at bay, the central bank has boosted the fed funds rate 12 straight times since last June, bringing the overnight bank lending rate to 4 percent. (Full story.)

Twelve straight days of rioting in France and anti-rate hike rhetoric from some European finance ministers have also undermined the euro in recent sessions, but analysts said the slide is likely to be limited as the markets will shift attention away from the upheaval once the situation calms down.

While Greenspan & Co. have steadily raised rates, their foreign counterparts have kept rates flat. The ECB kept rates steady at 2 percent at its November meeting, and the Bank of Japan has held its key rate near zero in a bid to foster a stop-and-go recovery in the world's second-biggest economy.

"We primarily see dollar strength because we're expecting one to two more rate hikes from the Fed. All that should be supportive," Kathy Lien, chief currency strategist at Forex Capital Markets, said recently.

The widening gap between U.S. rates and those abroad has made dollar-based investments more attractive to foreigners, fueling demand for dollars. But policy-makers in Europe and Japan are showing signs they may be ready to embark on their own rate-hiking campaigns.

The ECB held rates steady at its meeting this month, but the bank's policy statement echoed hawkish comments European central bankers have been serving up since October.

A Reuters poll of 60 economists published on Oct. 26 showed a majority of economists expecting a rate hike by June of next year, but several analysts now expect an increase to come sooner.

Lien said the market is now forecasting a hike sometime early next year, while Ashraf Laidi, chief currency analyst for MG Financial Group, thinks there's a 75 to 80 percent chance for a rate hike in December.

Just last week, the Bank of Japan also hinted it could end its ultra-easy monetary policy in fiscal 2006. That could provide support to the yen, which is trading at a 26-month low against the dollar.

Any more upside?

If Europe does raise rates in December, a gap between Euro zone rates and U.S. rates will still exist. Higher rates in the U.S. won't necessarily keep translating into dollar gains, though.

"It's all about anticipation," Laidi said. He expects the dollar rally to unwind as the Fed signals an end to its rate-hiking policy. Economists widely expect the central bank to stop raising rates sometime early next year. (Full story.)

David Solin, partner at Foreign Exchange Analytics, agreed. He expects the dollar to continue rallying in the next month or two "but the longer-term move over the last year is starting to move towards an end," he said.

If the dollar starts to retreat, American consumers can expect to pay more for foreign-made goods. They also won't be able to buy as much when they travel abroad.

But it's also good news for those who have invested overseas, as they benefit from a weaker dollar when they convert their foreign-currency denominated investments back into greenbacks.

As the mood in Europe shifts towards tighter monetary policy, attention may also return to the persistent thorn in the side of the dollar -- the widening deficit in the current account, the broadest measure of U.S. trade with other nations.

Rate hikes from the Fed have been enough to put the trade deficit to the side, for now. But from a longer-term view, the dollar is clearly under downward pressure from the deficit, said Pierre Ellis, chief economist of global fixed income at Decision Economics.

At 6.3 percent of GDP, the deficit is near its highest level on record, and shows few signs of correcting itself. That may force policy-makers to let the dollar fall, which makes U.S. exports cheaper overseas and could slow the growth of imports.

The current account deficit worries economists since the United States is borrowing heavily to finance it, and at some point, debtors have to pay back what they've borrowed.

Despite the pressure on the greenback on the horizon, analysts expect dollar-based assets to remain attractive, mainly because of the underlying strength and productivity of the U.S. economy.

"In terms of economic growth, the fundamentals are clearly on the side of the U.S.," Brian Bethune, U.S. economist for Global Insight, said. "We don't think there's going to be a lot of additional momentum, but even if (the dollar) treads water, it's still going to be an attractive investment."


For more about the downside of a rising dollar -- click here.

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