Watch the Greenback

Later today, the Federal Reserve Bank meets to decide whether or not they want to change their stance on interest rates. It is presumed in the markets that the Fed will do nothing and keep rates at 2%. However, Dallas Fed President Richard Fisher, who voted in favor of a quarter-point rate hike at the last meeting, will likely vote the same way at this meeting in June. Odds are that Philadelphia Fed President Plosser will do the same, as he, too, has been in the inflation camp. Right now, Fed Funds futures, probably the best metric we can look at to see what economists and strategists are pricing in for more moves, has a 64% probability that the Fed will increase rates by a quarter of a point at the October meeting. That number has been on a roller-coaster ride. At one point, the markets had priced in almost a three-quarter-of-a-point increase in rates in the October meeting and then Fed Funds futures corrected. The perception on the street in large measure has been that the Fed would not touch rates until January due to the increasingly weak economy.

Why do we care? Because it will have a direct impact on the U.S. dollar. The dollar rose to a six-week high against the Euro yesterday on slightly better than anticipated spending and consumption data. Here’s the big headline: The dollar is strengthening and may have neared a multi-year bottom. I like that. Why?

1. The Eurozone is starting to feel our pain. They’re not immune to the pullback in the global economy and record high oil prices. Frankly, their housing market has not faired much better than ours. The Eurozone economy is starting to see their economy unwind, led by the U.K.

2. Oil traded down to $119 dollars yesterday before closing at $121. Oil is down over 20% from its peak at $147. If you recall, and we’ve talked about this in the past, oil and the dollar trade in sympathy. The correlation between the two is a 0.9, almost 1. What does that mean? When the dollar rallies, oil dips. When the dollars sinks, oil rallies. Why? Oil is dollar denominated and high oil is a huge inflation gage. If inflation and record oil prices are hitting your wallet, that makes it more expensive to import oil -- meaning we can do less with our dollar because it is worth less. So while oil is down over 20%, the dollar is at a six-week high against the Euro.

3. The perception among most economists is that the Fed’s next move will be to raise rates, whether in October, January or in the first quarter of 2009. That means that the currencies markets have to correct for that. Why? Our currency is cheap and our rate of return on treasuries is low in large measure because of the exceptionally low interest rates in the United States. If the Fed’s policy stance shifts to raising rates in 2009 because they feel the U.S. economy will recover, then our dollar will get stronger, and the rate on our bonds will improve making U.S. treasuries and the dollar a better investment. Remember most foreign central banks who own the dollar have lost billions. They want a safe, secure and smart return on investment. They haven’t seen a lot of that in the past year but we may be turning the corner before Europe gets their act together. If that happens, the dollar will be appealing and the Treasury market will see strong demand.

Also note that the European Central Bank meets on Thursday but they are expected to leave rates unchanged at 4.25%. Remember they cut rates by a quarter of a point in their last meeting.