What could the end of rate hikes mean for the dollar?

At this time last year, many forex analysts and traders were fixated on the U.S. twin deficits (domestic and foreign) and how they would pressure the greenback in 2005. However, forex traders quickly shifted their focus to the more bullish Fed story earlier this year.

Market watchers voice concern that an end to Fed rate hikes in the U.S. could weigh on the overall dollar outlook into 2006.

“While the Fed is nearing the end of its tightening cycle, there could be other central banks that are going to enter tightening cycles,” Kasriel says.

That could spell a narrowing of the positive interest rate differentials that have recently been in the dollar’s favor. Kasriel believes the ECB, the Bank of Japan, and possibly even the Bank of England could potentially tighten rates in 2006.

“The dollar might have some rate competition from abroad,” he says. “I think the dollar will be weaker next year.”

Lehman’s Harris agrees. Into the first quarter, Harris sees potential for the dollar to remain strong “until investors see the Fed moving to the sidelines,” he says.

“Sentiment around the dollar should shift and the market should resume its longer-term decline.”

Harris and Kasriel both think the 2005 rally in the dollar is a shorter-term correction in the overriding longer term bearish trend. Harris sees potential for a 10-percent drop in 2006.