NEW YORK The reality of low interest rates and deep economic recession should finally start to catch up with the U.S. dollar in 2009, after risk aversion and de-leveraging helped push the currency to multi-year highs.
The advance -- which has pushed the dollar up almost 20 percent against a basket of six currencies .DXY since July -- is "artificial" and may subside once extreme risk aversion eases and global markets stabilize, analysts said.
"Foundations for the dollar's recent rally have not been solid. The result of repatriation, deleveraging, quantitative easing and a major scarcity of dollars," said Bob Sinche, head of global FX and rate strategy at The Bank of America in New York. "But now we are bound for a correction."
Sinche said euro/dollar may be trading at 1.38 by the end of December and that the dollar may rapidly dip to 1.44 to the euro by the first quarter of 2009 before the pair resumes a "more gradual sell-off."
The European currency was last trading in New York at $1.2804 compared with a record high of $1.6038 touched on July 15. Demand for the greenback rose as the financial crisis deepened and even as the Federal Reserve cut interest rates while the economy slowed.
"The dollar was at the receiving end of leverage flows and also concerns about the euro zone's ability to navigate its first systemic crisis," said Daniel Katzive, director for global foreign exchange at Credit Suisse Securities in New York. "But the U.S. currency is no longer very cheap. Actually, in same pairs, the undervaluation of the dollar has been erased remarkably quickly."
Goldman Sachs' senior investment strategist Abby Joseph Cohen also said on Thursday the U.S. dollar now is about at the level "it should be."
Katzive at Credit Suisse added it may be premature to call the end of de-leveraging and that price action in euro/dollar may be choppy until the end of the year.
However, he said extreme risk aversion is beginning to show signs of easing. And that combined with lower rates and a weak economy, this should start to add pressure on the dollar. The bank forecasts euro/dollar to trade as low as 1.23 in the near term but rebounding to 1.37 in about six months.
In a sign risk may be easing, most currency strategists in a Reuters poll released on Wednesday said they expect volatility in the euro, sterling and yen against the dollar to decrease in the next few weeks.
The poll implied monthly annualized volatility of 14.8 percent for the euro against the dollar in December, down from the 23.6 percent seen in November.
"If the equity markets manage to hold on to some of its gains, with some relaxation in risk aversion, we may see a pullback in euro/dollar," said Tom Fitzpatrick, chief technical analyst at Citigroup in New York. "Some weakening in the dollar is not inconceivable."
Still, for many analysts, the outlook for the dollar in the next couple of months will depend greatly on the impact that lower benchmark interest rates across the globe will have on multiple currencies.
Most major central banks have been cutting benchmark rates, aggressively trying to revive local financial markets and economies since the global financial crisis deepened in September.
This week alone, the European Central Bank, the Bank of England, Sweden's Riksbank and the Reserve Bank of New Zealand all matched or exceeded easing expectations at rate-setting meetings.
Earlier on Thursday the ECB cut interest rates by 75 basis points in its biggest move ever. Its main refinancing rate now stands at 2.50 percent, the lowest in nearly 2-1/2 years, but more than double the U.S. Federal Reserve's benchmark rate at 1 percent.
But while some analysts like Katzive at Credit Suisse expect interest rate differentials to gradually weigh on the dollar in 2009, others argue a correction won't be immediate.
"Global yield differentials are collapsing and it is perhaps just a few months before rates in the eurozone and the UK fall very close to the US rates," said Vassili Serebriakov, a senior currency strategist at Wells Fargo Bank in New York.
"But while rate convergence could remove some of the recent support for the dollar, once financial conditions stabilize and risk appetite returns, the yield attraction of currencies such as the pound and the euro over the dollar is likely to have disappeared," he added.
Wells Fargo forecasts euro/dollar will be trading at 1.26 in six months and at 1.28 in one year.
(Reporting by Vivianne Rodrigues; Editing by Chizu Nomiyama)