Dollar takes advantage of yield support

The dollar has continued to draw strength from yield considerations over the past few weeks, with a short-lived push to the 2005 EUR/USD low of 1.1870 in October.

Inflation and interest rate considerations will tend to dominate in the short term, especially with the jump in reported U.S. inflation. Consumer prices rose 1.2 percent in September, with the annual inflation rate pushing to a 15-year high of 4.9 percent.

Core inflation indicators have remained under control; the underlying consumer price index increase (CPI) held at 0.1 percent for September. The annual increase fell to 2 percent from 2.2 percent and the Federal Reserve’s preferred measures of inflation have held below 2 percent over the past few months. The central bank still fears the jump in energy and raw material costs will gradually feed wider inflationary pressures over the next few months.

The Federal Reserve has increased interest rates at its past 11 meetings and there is a strong probability it will tighten again at the beginning of November. Futures markets have priced in at least one further increase after that and there are expectations short-term rates will increase to 5 percent over the course of 2006, compared with current Euro levels of 2 percent. Ten-year T-note yield spreads over German bunds have also increased to levels last seen in 1999, but the Federal Reserve will need to anchor inflation expectations to sustain attractive real yields.