Subprime Woes Causes Bleak Outlook on U.S. Dollar

As U.S. interest rates remain unchanged at 5.25% for the 8^th straight Federal Reserve meeting, and as terrorist arrests in London spur worldwide concern, the U.S. dollar has dropped against major currencies. The dollar fell 0.5% to 1.3605 per euro and 0.6% to 122.44 yen. Investors have become more risk-averse with the recent geopolitical events. As a result, demand for the yen and the swiss franc, a haven for security, has increased. According to Derek Halpenny, senior currency strategist at the Bank of Tokyo-Mitsubishi UFJ in London, interest-rate differentials will continue to move against the U.S. dollar as a result of the unchanged U.S. monetary policy.  

This trend may continue in the long run. Despite recent positive reports of increased retail sales and job growth, investors are worried that losses from hedge funds owning subprime mortgage bonds will slow economic growth. This increase in risk aversion has caused an increase in holdings of risk free debt. Treasury holdings are at 35% of funds overseeing $315 billion in bonds. This is 1% higher than holdings in corporate and sovereign debt for the second consecutive week. In the previous month for the first time in a year, U.S. treasuries have outperformed corporate and emerging-market bonds.

Investors like Bill Gross of Pacific Investment Management Co. are speculating that the housing slump will restrain the economy for the rest of the year. The subprime mortgage crisis is the worst since 1991, and the effects may even be felt next year as well. Investors are speculating that the Federal Reserve will be forced to lower interest rates in the long run in order to induce consumption.

What will lower interest rates mean for the value of the U.S. dollar? Lower interest rates will cause a drop in the value for the U.S. currency. If the Fed does in fact decide to lower interest rates, in the attempt to avert further dampening effects on the economy by the housing meltdown, currency traders will decrease demand for the U.S. dollar. A decrease in demand in will bring down the value of the currency.