Dollar rally to continue amid global rate cuts

By Nick Olivari and Lucia Mutikani - Analysis

NEW YORK (Reuters) - Coordinated interest rate cuts by central banks around the world on Wednesday will do nothing to stop the U.S. dollar's advance given strong demand for liquidity and a safe haven.

World financial markets have been severely disrupted in recent weeks by a string of bank failures in the U.S. and Europe sparked by illiquid U.S. mortgage-backed debt.

The resultant loss of confidence prompted credit to dry up with banks reluctant to lend to each other and to consumers, prompting the U.S. Federal Reserve to ensure a supply of dollars through agreements with other central banks.

But in the latest act on Wednesday at least six central banks announced cuts to their benchmark rates by 50 basis points.

The Fed, European Central Bank, Bank of England, Bank of Canada, Riksbank and Swiss National Bank all acted in concert, with even the Bank of China lowering rates by 27 basis points.

"Right now the demand for dollars is so strong it completely trumps the low interest rate that the fed is offering," said Boris Schlossberg, director of FX research at GFT in New York.

The ICE Futures Exchange U.S. dollar index has already gained almost 13 percent since its trough in March ending a seven year decline even as the current financial crisis unfolded.

Typically interest rate cuts erode demand for fixed income assets and reduce demand for the currency to buy them but given the coordinated action, rate differentials have remained the same.

And given one over-riding concern is the lack of dollar liquidity, a reduction in rates to borrow greenbacks will add to the flow of dollars to the market.

INVESTORS PILING INTO DOLLARS

Investors have also been piling into U.S. dollars and dollar-denominated securities on the assumption that the U.S. is perhaps the safest place to be should the economic malaise strike any deeper.

"Further Fed cuts will maintain the view that U.S. policy makers are less behind the curve than their peers, which is dollar positive," said Adam Cole, global head of foreign exchange strategy at RBC Capital Markets in London in a note to clients.

The flight to safety has decimated the carry trade where investors borrowed in a low yield currency like the yen and bought assets in higher yielding currencies such as the Australian and New Zealand dollars.

The Australian dollar has plunged 32 percent against the dollar since peaking in mid July as investors became risk averse as ripples from the U.S. banking crisis spread globally.

The yen has gained 11 percent against the dollar since mid August when investors began fleeing the carry trade in earnest but the dollar's losses have been limited to the Japanese currency alone.