Interest rate changes will push dollar lower

THE euro is testing a two-year high against the dollar as we go to print, and before the year is out, we could well see it rise to tackle $1.36 — the euro’s lifetime high, reached on New Year’s Eve 2004.

So what’s driving this rally in the single currency? Let’s consider US and eurozone factors separately.

First of all, let’s not forget that we’re just three days away from the next hike in the eurozone interest rate cycle. On Thursday, the Governing Council of the European Central Bank will meet, and if the council is as good as its word, we can be certain that rates will rise by 0.25% this week.

We’re certain of a hike because ECB president Jean-Claude Trichet effectively pre-announced the move in his last press conference in early November. When he spoke on November 7, Mr Trichet called for “vigilance” with regards to inflationary pressures, and since a call to vigilance has preceded each of the past five hikes in this cycle, we can be certain that November’s warning will be followed by a December hike.

So the prospect of an immediate eurozone rate hike is boosting the euro — but so too is the prospect of even further hikes next year.

The German central bank governor Axel Weber recently said that the inflation outlook for 2007 was “alarming”, and in November, his Dutch counterpart, Nout Wellink, said that euro interest rates were “damn low”.

Both sound like men intent on pushing rates beyond the 3.5% level we’ll reach this week. Markets have finally realised that the ECB might yet push rates all the way to 4%, and this realisation is boosting the euro further.

Meanwhile, on the other side of the pond, it’s clear that the opposite is the case. American interest rates have reached a peak and seem certain to fall next year.

Recent released US data supports this view, including disappointing retail sales activity, falling house prices and weak consumer confidence levels. What’s more, with oil prices stabilising, inflationary pressures in the US are abating, so the Federal Reserve has less reason to risk pushing rates even higher.

We’ve long believed that US rates will fall in the year ahead, and the market has finally accepted this inevitability. We look for the first cut in US rates towards the end of spring, and we think the Fed could easily cut on four separate occasions over the coming 12 months.

In short, rising euro interest rates and falling US rates are the key drivers behind recent currency moves, and we expect more of the same next year. Few will want to hold the dollar when US rates start to fall.

The views and opinions expressed in this article are those of the author and do not necessarily correspond with those of Ulster Bank or any other member of the RBS Group.