Since the last G7 meeting about two weeks ago the price action of the US Dollar suggests that an important bottom may have been reached against the Euro. The Euro made an all time high against the Dollar at just above 1.6000 only three trading days ago. The 1.6000 level was a widely anticipated one by forex traders. Early Thursday morning on April 24, 2008 we are just under 1.5700, so a sharp reversal in underway at the moment.

The same type of price action can be seen in Dollar Yen. From a recent low of under 100.00 the Dollar is trading about 104.00 this morning and looks ready to move quickly to challenge the 105.00 level.

While a few day trading action does not make a trend the Dollar’s new strength must be respected. While the FED reserve will probably cut interest rates again at its’ April 28th and 29th meeting forex and bond traders expectations are now that the rate cut will be only by 0.25 basis points instead of the 0.50 basis point cut expected just a few days ago.

This change in sentiment is caused by the increased inflationary pressures that are occurring in the US and indeed around the world. With a lower Dollar helping to accelerate the increase of all imported goods into the US inflation has flared up in an alarming way, especially in crude oil prices and food prices.

The Fed has a tough decision to make at its next meeting. A 0.25 point rate cut would signal that the rate reduction business is over and that the Fed will begin to focus on fighting inflation even if it means that the economy slides further into a recessionary phase.

This is what the forex markets seem to be anticipating and would explain the sudden strength in the Dollar. Once the Fed actually increase rates you can expect to see the Dollar zoom to the upside. We could be back to 1.3500 Euros to the Dollar.

Interestingly enough once the Fed starts to increase interest rates the stock market will likely take a big hit and the tendency of the risk trades in Dollar/Yen to track movement in the stock market would be broken.
This means as stocks and bonds fall the Dollar would tend to rise.

Certainly, it is too early to tell if an important top against the Dollar has been reached by the Euro. The Eurozone economies have their inflation rate kicking to the upside too and seem to be willing to raise rates in an effort to bring the inflation rate down. It is therefore possible that the US will begin to increase rates but will be confronted with increased rates from the Eurozone as well.

It is the interest rate differentials between the Euro and Dollar that traders will be focused on. If the interest rate differential begins to widen in favor of the US currency you would expect that the Dollar will gain ground against the Euro.

Taipan is the pen name used by a retired forex trader and portfolio manager who worked in Asia for over 20 years. The nickname was acquired in Hong Kong and is now used for a number of financial related blogs. One of them is at Forex Trading Guru