Dollar's Rebound Tied to Hopes for US Economy

Signs of renewed confidence in the U.S. financial system could support the dollar next week, provided March's housing reports do not show sharp falls and revive the chances of a steep interest rate cut this month.

Quarterly results from the largest U.S. bank, Citigroup, on Friday, although worse-than-expected, gave investors hope the credit crisis was nearing an end, sparking broad equities and dollar rallies.

Exchanging Dollars and Euros
Exchanging Dollars and Euros

The credit squeeze was triggered by the housing slump in the United States, where financial institutions advanced loans to homeowners who were ill-equipped to repay them.

"Probably for the first half of the week, the dollar will continue to take its cue from the equity market performance. If we see renewed confidence in the U.S. financial system, the dollar could continue to benefit," said Omer Esiner, forex analyst at Ruesch International in Washington.

But analysts cautioned that gains for the dollar on an improved risk appetite and rising stocks could be erased if U.S. existing and new home sales data for March, due in the coming week, showed signs of deeper troubles in the housing sector.

Housing starts data this week suggested that the pace of the sector's decline was intensifying, contributing to the euro's push to record highs above $1.59 to the dollar.

A recovery in the housing market is seen as a necessary precondition for the broader economy to regain its strength.

"More disappointing data in the U.S. would probably erase some of the dollar's recent gains and likely fuel talk of a more aggressive 50-basis-point interest rate cut from the Federal Reserve at the end of the month," said Esiner.

"Having said that, further gains on Wall Street and equities abroad could keep dollar/yen underpinned in an otherwise weaker market for the dollar." The U.S. stock market's performance will be determined by financial results from, among others, Bank of America , Merck and soft drink and snack maker Pepsico .

Interest rate futures are currently pricing a roughly 12 percent chance of a half percentage point reduction in the Federal Reserve's overnight lending rate to 1.75 percent at the April 29-30 meeting.

The Fed's aggressive rate cuts since mid-September have undermined the dollar against the euro, with European Central Bank President Jean-Claude Trichet and other ECB policy-makers showing little sign of moving toward monetary easing as it maintains its inflation vigil.

Analysts said this will prevent investors from aggressively selling the euro in the near term.

"It seems pretty clear they will not be cutting interest rates soon.

Trichet needs to reaffirm his 'Mr euro status'," said Michael Woolfolk, currency strategist at Bank of New York Mellon in New York.

"It's pretty clear that despite the whinging going on, on behalf of euro zone ministers, that they will continue on their hawkish stance.

Unfortunately for the European ministers, that will mean tighter monetary policy and a stronger euro." Eurogroup Chairman Jean-Claude Juncker said on Thursday markets had failed to understand the message from the Group of Seven financial leaders on foreign exchange and criticized the euro's surge to fresh highs.

Woolfolk reckons the euro will rise above $1.60 against the dollar in the coming weeks and sees the single currency scaling new highs versus sterling above 81 pence.

"Even though we have backed away from 1.59 (on euro/dollar), I do think there is upward pressure on the dollar.

I believe we are going to trade above 1.60 next week," said Woolfolk.

"The best thing right now for the dollar would be for the Fed to cut 25 basis points and prepare the market for a pause by indicating that the economy is beginning to stabilize, but talking up the U.S.

economy at this point is 50 percent wishful thinking," he said.

An expected deep interest rate cut in Canada could boost the greenback against its Canadian counterpart.