Thursday, December 6, 2007

The USD and EU Inflation

Jim Jubak wrote a great piece on the woes of the USD this past Tuesday. The article focuses on inflation in the European Union affecting the USD. The entire article is worth reading, but I highlight a very significant portion below.

I'll admit I don't know what the two banks will decide Thursday and Dec. 11. But I do know what will happen if the interest-rate gap between the two currencies shrinks further:
  • The U.S. dollar will fall, and the euro will climb.
  • The price of oil, which trades in U.S. dollars, will go up again, as oil producers adjust prices so that they at least break even on the dollar's decline.
  • Gold prices will climb as investors seek an alternative to the U.S. dollar as well as safety from uncertainty about the global economy and a likely bump in U.S. inflation.
  • U.S. equities will rally in the days after a Federal Reserve rate cut but then give much of the gains back as overseas investors pull money out of the U.S. financial markets in response to the dollar's weakness.
Today the ECB held their target rate at 4.0% instead of raising it, as Jim anticipated. The overnight interest rate spread between the US and EU remains 50 bps (instead of falling to 25 bps if the ECB had raised their rate). That may give the Fed a bit more breathing room to cut by 50 bps instead of 25.

As of today, the Fed Funds Futures market expects a 60% probability of a 25 bps cut and a 30% chance of a 50 bps reduction using January options (click for image). Using December options, the expectation is about 50% for both 25 and 50 bps reductions. You read that correctly, nearly a 100% expected probability of a rate cut.

The dollar's perfect storm worsens
Jim Jubak
Jubak's Journal, 12/4/2007 12:01 AM ET

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