Bottom line: Has dollar bottomes

The U.S. dollar got slammed in the first half of 2007, especially in July when the euro and pound sterling reached multi-year highs against the dollar. Most of the analysts we spoke with agree the dollar may have set a bottom, but for the dollar to make a serious recovery, economic reports need to support it.One sign of a change in the dollar’s current downtrend is that the psychological support of 80.00 in the U.S. Dollar Index is holding. The Dollar Index took out the 2005 lows and briefly broke the 80.00 level on Sept. 24 and again on Aug. 6, but it rebounded both times (see “ Is this the bottom?” below). The Dollar Index hasn’t been this low since 1992.

“If Dollar Index futures do fall below 80.00, this sets up a potential test of the 1992 lows in the 78.50 to 79.00 area,” says Heather Mitchell, market analysts at optionsXpress. But the consensus see ms to be that 80.00 will hold. The key factor for the U.S. outlook is going to remain the health of the U.S. consumer.

Brian Dolan, director of research at Forex.com, says watching the labor markets will be key for the rest of the year when looking for a signal of dollar strength. As long as there’s a 4.5% to 4.8% unemployment rate, the job market can still be considered solid. Unemployment inched up to 4.6% in the July report released Aug. 3.

“How we are weathering the housing market downturn will also play a factor in the dollar’s perceived strength,” Dolan says, adding, “The recent credit driven squeeze is unsettling markets and this will keep risk aversion high and carry trades low. The U.S. dollar generally does well against other currencies (except for the Japanese yen) in times of widespread market turmoil, as a safe haven destination of last resort.”

Gross domestic product (GDP) also will be important to watch while the dollar attempts to recover in August and September, according to Dolan. “On Oct. 31 the third quarter advanced GDP report will be released and the breakeven line would be 2.5%,” Dolan says. “Anything north of that would support the dollar and anything above 2.8% would be very dollar-supportive, while anything below 2.5% will hurt the dollar and anything below 2% will lead to a dollar-selling scenario

C AN $ REBOUND ?

Why has the dollar been struggling and what’s going to signal a change?

Joseph Trevisani, chief market analyst for FX Solutions, says there are a number of problems for the dollar but the biggest is that it is losing ground on interest rates.

“The primary ill is the interest rate differential between the central banks of its major trading partners and the Fed,” he says, adding that the European Central Bank (ECB) is most likely going to raise rates by a quarter-point in September, and then again before the end of 2007, stopping at either 4.25% or 4.5%. The Bank of England (BoE) probably also will raise rates in September by a quarter point.

“European economies are showing signs that growth cannot continue at its current rate, which is above trend,” Trevisani says. “Their long-term trend growth is around 2% and they’re currently running between 2.5% to 3.0%. “ With the actual growth in the European economy starting to slow down, the ECB will be more disposed to ending their rate increases.”

Also , for the last decade the U.S. economy has consistently outperformed the Euro zone economies in growth, but for the past 12 months that has not been the case. When the growth advantage shifts back to the U.S. economy, it will be a signal that the U.S. dollar is set to recover, adds Trevisani. He pegs the euro between 1.26 and 1.30 by the end of 2007, adding that secondary indicators used to predict growth in the United States like job growth and consumer sentiment numbers have all turned up during the last two months, which shows returning economic growth.

EUR/USD

The euro set its all-time high against the dollar this summer and some analysts say it has peaked. “The euro has hit the apex of euro euphoria and there will be a downtrend in euro sentiment overall and an improvement in U.S. dollar sentiment,” Dolan says, adding, “In about three months, the EUR/USD will be at about 1.30 to 1.35, and if it goes below 1.30, then look for it to be at 127 or 128.”

Ian Copsey , senior financial analyst at GFT, agrees, saying: “Following the completion of the rally to 1.40 or 1.41 by the end of August, we should see a correction to the entire rally from 1.1640 (from November 2005). This is expected to be between 41.4% to 50% percent of the rally, implying support between 1.2850 and 1.3050. With the cycles due to find a low around that time, this is the target for year-end.”

Mitchell adds the euro has found increasing support from non-U.S. central banks as they look to diversify out of their accumulated U.S. dollar reserves, and if this trend continues, a test of psychological resistance at 140 is a possibility by the end of 2007. “In July, neither the sentiment indexes nor the Euro zone CPI gave euro bulls reason to worry as the 1.9% CPI [keeps] the door open for an ECB rate hike in the third quarter,” says Ashraf Laidi, chief FX analyst at CMC Markets US. “The Euro zone Economic Sentiment Index slipped 0.7 of a point to 111.0. The day’s U.S. figures have the potential of triggering renewed gains,” Laidi adds.