The dollar is back on the defensive against the euro after pushing the European Economic Union currency back nearly 40… … pips from its record high from mid-2008. After touching $1.61, the euro, along with the British Pound, have dropped massively against the buck over the last few months.

The euro made three separate moves to $1.25 between October and November but after standing up to dollar pressure, the currency is now closing in on $1.43, roughly midway back to its all-time high. Slumping oil was a major catalyst for the slide of the European currencies against the dollar from July to November. The recognition by speculators that the US economic woes were really a global challenge also caused other major currencies to fall.

Most analysts credit the dramatic interest rate cuts in recent months for the euros quick rebound. It has been roughly one month since the dollar made its final push to knock the euro back to $1.25. Since that point in late November, the euro has climbed nearly 18 points. This is a remarkable move in not even 30 days time. Even more remarkably – the euro has gained 15 pips on the greenback in the last 8 days.

The Fed cut its funds rate by three-quarters of a point Tuesday, to .25 per cent. This helped spark widespread drops by the dollar against major currencies. Low interest rate yields are an important speculative factor in currency trade during times of economic uncertainty. With the high risk investment prospects posed by currency speculation, currency differentials are often used to offset risk of loss. As was the case with the yen when it was at a zero per cent basis late 2007, the dollar is now a target for carry trade.

The carry trade is when speculators hedge against losses by using currencies with a low cost to borrow (such as the dollar at the moment) to buy currencies with a higher interest rate yield. This enables the trader to collect a daily interest rate rollover. The simple promise of a consistent interest yield makes a given currency more viable. The dollar has much working against it at the moment with its low cost to borrow and the weak economic picture in the US. Concerns about a deepening recession throughout 2009 offer little incentive for speculators to buy back the buck anytime soon.

The dollar still remains weak against the yen as well. Since mid-September, the dollar is down about 17 pips against the Japanese currency. For years, speculators used low cost to borrow yen to trade for higher yield currencies. The unwinding of the carry trade with the yen has been ongoing for much of the year and is “winding down” itself. Investors who had used the yen to buy dollars, euros and pounds have been reversing their ratios as the economic situation grows worse. One dollar is worth just over 89 yen at the moment.

Deflation concerns have grown more intense recently has some economists are worried that the interest rate cuts have rapidly devalued the dollar to the point that it is going to adversely effect the ability of the economy to turn around. A weaker dollar benefits some while posing a challenge to others. Foreign investors like to use their stronger currencies to buy into American investments when the dollar is weak, as it makes prices “cheap”. Similarly, a relatively weak dollar means American companies cannot get as much for their dollars when dealing in foreign entities.

Market Recap

The Dow dropped 99 points Wednesday as investors juggled with the prospects of an economic turnaround. The Fed rate cut has led to some low mortgage rates in many places. Oil is below $40 per barrel despite a record output production cut from OPEC. Thursday, the Dow was down 219 points. The Bush Administration is considering helping with an “orderly” auto bankruptcy to help the Chrysler and GM have a soft landing if they run out of cash. Oil moved up a bit after Wednesday’s sharp fall.

Neil Kokemuller
Friday, December 19, 2008
12:46 AM EST

Neil Kokemuller is an Associate Professor of Marketing at Des Moines Area Community College in Des Moines, Iowa, USA. He has a MBA from Iowa State University.

Please note: The information provided in this article is intended for informational and entertainment purposes, and not as advice for financial decisions or investments. Actions taken on the basis of the information shared is at the sole risk and discretion of the individual. Currency investment poses significant risk of loss.