Dollar Falls Against Euro on Concern Economy Nears Recession

By Bo Nielsen and Ye Xie

Jan. 26 (Bloomberg) -- The dollar fell against the euro and the pound after the biggest interest rate reduction in almost 18 years by the Federal Reserve wasn't enough to convince traders the world's biggest economy will avoid a recession.

The U.S. currency declined this week as traders bet the Fed will lower its target lending rate by a half-percentage point at its meeting next week after an emergency cut on Jan. 22. The yen gained against the euro yesterday for the first time this week as a drop in U.S. stocks led investors to sell high-yielding assets and pay back low-cost loans from Japan.

``The Fed easing or not, the economy is in deep trouble,'' said Lane Newman, director of currency trading in New York at ING Financial Markets LLC. ``The negative trend for the dollar still remains.''

The dollar fell 0.4 percent to $1.4681 against the euro from $1.4621 on Jan 18. It decreased 1.4 percent to $1.9828 per pound from $1.9554. The U.S. currency was little changed at 106.72 yen, compared with 106.87 a week earlier. Japan's currency fell 0.5 percent to 157.02 per euro from 156.20.

The dollar lost 1.5 percent against the euro since the Fed unexpectedly cut its target rate for overnight lending by three- quarters of percentage point to 3.5 percent this week.

The yen rose against all of the major currencies yesterday as a 1.6 percent retreat in the Standard & Poor's 500 Index limited the carry trade. Japan's currency increased 3.3 percent against the Brazilian real, 2.7 percent against the New Zealand dollar and 2.4 percent against the Norwegian krone.

Japan's Rate

The Bank of Japan this week kept its benchmark rate unchanged at 0.5 percent, the lowest among industrialized countries, while its Norwegian, New Zealand and Brazilian counterparts maintained their rates at 5.25 percent, 8.25 percent and 11.25 percent, respectively.

In the carry trade, investors get funds in a country with low borrowing costs and buy assets where interest rates are higher. The risk is that fluctuating exchange rates can erase profits.

``Risk aversion is still high and could flare up again anytime,'' said Shaun Osborne, chief currency strategist at TD Securities Inc. in Toronto. ``Low-yielding currencies like the yen do well in such an environment.''

Fed's Cut

The implied volatility on the three-month euro-dollar option rose to as much as 9.9 percent on Jan. 22, the most since July 2006, as investors bet currency markets will continue to fluctuate more than usual in the months ahead. The two-year average is 7.2 percent.

The Fed's cut in the federal funds target was the biggest single reduction since the Fed began using the rate as the principal tool of monetary policy in 1990. It came just over a week before policy makers' scheduled meeting on Jan. 30.

``Broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households,'' the Fed said in a statement in Washington after the cut. The Federal Open Market Committee took the action ``in view of a weakening of the economic outlook and increasing downside risks to growth.''

The U.S. currency fell against the euro as traders increased bets that the Fed has more cuts to make. Futures on the Chicago Board of Trade showed a 72 percent chance the Fed will cut its target rate by a half-percentage point next week to 3 percent, compared with zero chance a week ago. There's a 68 percent chance of a reduction to 2.75 percent at the March 18 meeting of policy makers.

UBS on Economy

UBS AG, the world's second-largest currency trader, predicted on Jan. 24 that the U.S. will slide into recession in the first half. Deutsche Bank AG, the world's biggest trader, said the dollar will fall beyond its all-time low of $1.4967 per euro in the same period.

``The market is still bearish on the dollar; nothing has changed,'' said Manfred Wolf, director of foreign exchange sales at HVB Bank in New York.

A report may show sales of new homes in the U.S. fell to the lowest level in 12 years last month, according to the median forecast of 54 economists surveyed by Bloomberg News. The report from the Commerce Department is due on Jan. 28.

The yield advantage of a two-year German bund over a similar-maturity Treasury rose 0.15 percentage points to 1.28 percent this week, making the dollar-denominated security less attractive. The yield spread was 0.87 percent on Dec. 28.

To contact the reporters on this story: Bo Nielsen in New York at bnielsen4@bloomberg.net ; Ye Xie in New York at yxie6@bloomberg.net .

Last Updated: January 26, 2008 09:02 EST

Source : Bloomberg.com