Dollar is driven interest differential expectations

The dollar has come off its lows since the middle of November because of changing expectations about the direction of interest rates outside of the United States. Up until recently, the United States was alone with its active policy of reducing rates. This lowering of interest rates by the Fed along with the lower rate expectations by fixed income investors caused the interest differential to move either against the US or to less favorable terms. A loose monetary policy in the US relative to the rest of the world will have the impact of increasing relative money supply which will lead to dollar depreciation. The economics are straightforward and transparent. However, the credit issues of the US have spilled over to other countries. In particular, the UK is seeing its own credit crisis issues as measured by short-term LIBOR rates. Consequently, there has been policy change by the Bank of England with a cut of 25 bps by the MPC for the first time in two years. This closes some of the gap that formed between the UK and US. There is similar talk of cutting rates in Europe based on slower growth and there are the longer-term expectations in the US that the economic outside of the housing is doing better than expected.

All these policy adjustments change the future expectations of interest rates which really drive the interest differentials or more precisely the expected interest differentials. If there is less drag from interest differentials, there will be greater opportunity for more dollar upside.