Forecasts for stronger dollar from currency strategists

Currency strategists, as surveyed by Bloomberg, are calling for a 1.39 euro/usd by the end of the year versus the current forward rates that are calling for a 1.45 euro/usd. The distribution of forecasts is clearly skewed to a lower euro. What a difference a few weeks make. In late November, the dollar was pushing all time lows yet now forecasters are expecting a strong rebound. The yen at the same time is expected to rally over this same period. So what is driving this forecast? Because we do not have access to all of the explanations behind the forecasts, it is interesting to reverse engineer the conditions that may be needed to get a stronger dollar using simple exchange rate models.

The economic drivers from exchange rate models should be consistent with the forecasts. For example, the forecasters must be assuming that there will be a change in the interest differential which will be favorable for the dollar. Since the current interest difference as determined by the forward rates is zero, the median forecast suggests that Euroland rates will have to fall relative to the US. The ECB will engage in actively pushing rates down relative to the Fed. This is only like to happen if there is a substantial slowdown in European growth and less likelihood of a recession in the US. The Fed will either be on hold or only be willing to engage in moderate cutting during 2008 which will be matched by the ECB. Inflation will have to be relatively stable or more moderate in the US.

The outflow from the dollar will have to be curtailed in 2008 or there will have to be a strong demand for investing in the US as measured by M&A activity. The buying of dollar assets may quicken if there is a fall in equity values in the US relative to the rest of the world.

If you believe that traditional exchange rate relationships will hold, then a dollar rally will have to be consistent with some of these fundamentals otherwise the dollar forecast has to be based on sentiment or relationships which are unexpected. We do not believe in either of these two scenario. Over the next year, we do not believe the dollar will be have sentiment leading to a rally or be out of step with fundamental relationships.