GDP and interest rates

Analysts point to expectations for more U.S. Fed rate hikes as one of the key factors stalling the recent rally toward the $1.23 level. While talk had been circulating in late 2005 that the Federal Open Market Committee (FOMC) was close to finishing its current rate hike cycle, a spate of stronger-than-expected economic reports in the first two months of the year have renewed expectations of additional hikes.

“The near-term outlook (for the dollar) is really predicated on bullish interest-rate differentials,” says Charmaine Buskas, economist at Moody’s Economy.com. “As long as near-term data suggests the Fed will raise rates through the first quarter, the dollar will continue to see strength.”

U.S. fourth-quarter gross domestic product (GDP) data was slightly below expectations at 1.1 percent. However, economists now believe that was just a temporary blip in an overall solid economic expansion phase. Current forecasts are for first quarter 2006 GDP to be as high as 4.7 percent. That is the forecast from both Credit Suisse and Moody’s Economy.com.

“Coming into the year, the supposition was the Fed had one rate hike left,” explains Jamie Coleman, managing analyst at IFR-Forex Watch. “But, over the last six weeks that perception has really changed. The U.S. economy is growing much stronger than people had expected. We are seeing a vigorous rebound in the first quarter.

“Now, maybe the ECB might have only one rate hike coming up. GDP in the Eurozone in the fourth quarter was soft,” he adds.

The Eurozone’s base interest rate currently stands at 2.50 percent after a 25-basis point increase on March 2. Recent data from the EU’s statistical office revealed that 2005 GDP growth was a tepid 1.3 percent, down from 2.1 percent in 2004. That still lags the U.S. economy, which is seen growing at about 3.5 percent. The next ECB meeting will occur April 6.

Positive interest rate differentials clearly favor the U.S. dollar vs. the euro, as the Fed funds rate currently stands at 4.50 percent, with the next FOMC meeting set for March 28. While some Fed watchers speculated the U.S. FOMC might pull in the reins on additional tightening at the 4.50 - 4.75 percent region, some analysts are now forecasting additional hikes to the 5.00-5.50 percent range before this cycle is over.