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Published On: Tue, Jul 29th, 2014

Dollar gains as the Fed seen rising rates first

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Expectations the FED will start tightening monetary policy first sends the dollar rallying against its counterparts.

The dollar gained 1.6 percent against the euro

Last week, Fed Chair, Janet Yellen, stated that interest rates may rise sooner than previously anticipated, though accommodative monetary policy is still warranted for some time. This fueled speculation that the Federal Reserve is getting ready to increase interest rates before other main central banks around the world.

This came in a sharp contrast compared to the ECB, on one hand, which moved its deposit rate into a negative territory last month and sent a strong signal to markets that further easing measures were expected. On the other hand, the Bank of Japan buys the equivalent of $69 billion of government debt per month, in a fight against its 15-year old deflationary spiral.

The developments are positive for the dollar, which has gained strength against a basket of other currencies. Apparently, the dollar is nearing a turning point, with the uptick seen in the front end of the yield curve.

Analysts expect the first rate increase to come next year, the first such forecast since 2006. The Fed is on its way to end the currency depreciating bondpurchase program by the end of 2014, which gives power to dollar bulls.

This month, the dollar gained 1.6 percent against the euro, touching $1.3438 today, a level unwitnessed since November 2013. There has also been a soaring demand for US assets, which brought the Standard & Poor’s 500 to its highest level, whereas Treasury yields declined to their lowest in a year.

The US central bank has retained the record low benchmark rate, 0-0.25 percent, since December 2008. Traders have been pricing in an increase of 0.17 percentage point. Fed tightening always entails a positive impact for the dollar. The rate increase is expected to be faster paced than previously anticipated.

There is also the chance, however, that with reasonably slow inflation and a slack labor market, higher rates may be delayed for the second half of 2015, or for 2016. As Yellen pointed out on July 15, with the faster improving market, the Fed funds rate increases can set in sooner. She also pointed out to lawmakers, however, that the central bank should continue applying stimulus, owing to the not yet fully recovered labor market.

The US unemployment rate dropped to 6.1 in June, the lowest in a six-year period. Consumer prices marked a hike for the first half. The Fed inflation gauge increased 1.8 percent for a year in May, the highest since October 2012, against the 2 percent target of the central bank. Dollar gains were due to rising consumer prices and low rate yields on US bonds. The real yield was 0.41 percent, nearing a 15 month low.

As for the euro, it is expected to drop 2 percent to $1.32 by the end of this year, and the yen is to weaken to 105 per dollar, by 3 percent.

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