The U.S. dollar got slammed in the first half of 2007, especially in July when the euro and pound sterling reached multi-year highs against the dollar. Most of the analysts we spoke with agree the dollar may have set a bottom, but for the dollar to make a serious recovery, economic reports need to support it.

One sign of a change in the dollar’s current downtrend is that the psychological support of 80.00 in the U.S. Dollar Index is holding. The Dollar Index took out the 2005 lows and briefly broke the 80.00 level on Sept. 24 and again on Aug. 6, but it rebounded both times (see “Is this the bottom?” below). The Dollar Index hasn’t been this low since 1992.

“If Dollar Index futures do fall below 80.00, this sets up a potential test of the 1992 lows in the 78.50 to 79.00 area,” says Heather Mitchell, market analysts at optionsXpress. But the consensus seems to be that 80.00 will hold. The key factor for the U.S. outlook is going to remain the health of the U.S. consumer.

Brian Dolan, director of research at Forex.com, says watching the labor markets will be key for the rest of the year when looking for a signal of dollar strength. As long as there’s a 4.5% to 4.8% unemployment rate, the job market can still be considered solid. Unemployment inched up to 4.6% in the July report released Aug. 3.

“How we are weathering the housing market downturn will also play a factor in the dollar’s perceived strength,” Dolan says, adding, “The recent credit driven squeeze is unsettling markets and this will keep risk aversion high and carry trades low. The U.S. dollar generally does well against other currencies (except for the Japanese yen) in times of widespread market turmoil, as a safe haven destination of last resort.”

Gross domestic product (GDP) also will be important to watch while the dollar attempts to recover in August and September, according to Dolan. “On Oct. 31 the third quarter advanced GDP report will be released and the breakeven line would be 2.5%,” Dolan says. “Anything north of that would support the dollar and anything above 2.8% would be very dollar-supportive, while anything below 2.5% will hurt the dollar and anything below 2% will lead to a dollar-selling scenario.”

CAN $ REBOUND?

Why has the dollar been struggling and what’s going to signal a change?

Joseph Trevisani, chief market analyst for FX Solutions, says there are a number of problems for the dollar but the biggest is that it is losing ground on interest rates.

“The primary ill is the interest rate differential between the central banks of its major trading partners and the Fed,” he says, adding that the European Central Bank (ECB) is most likely going to raise rates by a quarter-point in September, and then again before the end of 2007, stopping at either 4.25% or 4.5%. The Bank of England (BoE) probably also will raise rates in September by a quarter point.

“European economies are showing signs that growth cannot continue at its current rate, which is above trend,” Trevisani says. “Their long-term trend growth is around 2% and they’re currently running between 2.5% to 3.0%. “With the actual growth in the European economy starting to slow down, the ECB will be more disposed to ending their rate increases.”

Also, for the last decade the U.S. economy has consistently outperformed the Euro zone economies in growth, but for the past 12 months that has not been the case. When the growth advantage shifts back to the U.S. economy, it will be a signal that the U.S. dollar is set to recover, adds Trevisani. He pegs the euro between 1.26 and 1.30 by the end of 2007, adding that secondary indicators used to predict growth in the United States like job growth and consumer sentiment numbers have all turned up during the last two months, which shows returning economic growth.

EUR/USD

The euro set its all-time high against the dollar this summer and some analysts say it has peaked. “The euro has hit the apex of euro euphoria and there will be a downtrend in euro sentiment overall and an improvement in U.S. dollar sentiment,” Dolan says, adding, “In about three months, the EUR/USD will be at about 1.30 to 1.35, and if it goes below 1.30, then look for it to be at 127 or 128.”

Ian Copsey, senior financial analyst at GFT, agrees, saying: “Following the completion of the rally to 1.40 or 1.41 by the end of August, we should see a correction to the entire rally from 1.1640 (from November 2005). This is expected to be between 41.4% to 50% percent of the rally, implying support between 1.2850 and 1.3050. With the cycles due to find a low around that time, this is the target for year-end.”

Mitchell adds the euro has found increasing support from non-U.S. central banks as they look to diversify out of their accumulated U.S. dollar reserves, and if this trend continues, a test of psychological resistance at 140 is a possibility by the end of 2007. “In July, neither the sentiment indexes nor the Euro zone CPI gave euro bulls reason to worry as the 1.9% CPI [keeps] the door open for an ECB rate hike in the third quarter,” says Ashraf Laidi, chief FX analyst at CMC Markets US. “The Euro zone Economic Sentiment Index slipped 0.7 of a point to 111.0. The day’s U.S. figures have the potential of triggering renewed gains,” Laidi adds.

USD/JPY

The end of carry trades in the USD/JPY is another huge identifier that the dollar is due for a trend reversal. Carry trades have been among the driving factors in the direction of the yen, as traders and investors had been selling yen and buying higher yielding currencies such as the euro, the Australian dollar and the New Zealand dollar.

“The USD/JPY is a different story and there is little fundamental justification for a stronger yen during the next six months,” Dolan says. “It’s more of a political positioning that’s leading to the unwinding of the yen carry trades, which will be a major theme for the remainder of the year. We’ve probably topped out for most of the yen cross pairs for the time being. For the USD/JPY we’ll see a drop down to the 1.14 to 1.17 area by the end of the year,” he says.

Copsey has a similar view, adding, “Following the decline to the 114.40 to 115.20 target area around the end of August, we should see a steady rally into the end of the year, and probably through some of next year as well. This should rally back to around 122 to 124 by the end of December."

However, the recent flight to liquidity in the wake of the subprime loan situation has caused the unwinding of many carry trades, helping to strengthen the yen of late.

“There has been a paradigm shift in the currency market whereby the dynamics are transitioning into broad dollar weakness — the unwinding of carry trades are now not only producing yen gains, but broad U.S. dollar declines,” Laidi says, adding the yen is typically weak against the U.S. dollar and now the yen is gaining against the dollar.

But Trevisani says the BoJ is expected to raise rates once or twice more by the end of the year, and when they do that, it will start to bring an end to the carry trade, and the carry trade will reverse quickly because there are a number of large positions (see “Tech talk,” below).

“The primary factor undermining the Japanese yen is the interest rate differential between Japan and its trading partners. This disparity is so great that it subsumes all other factors,” Trevisani says. The U.S. Fed Funds rate is 5.25%; the Japanese equivalent is 0.5%. Similar or greater rate spreads exist between the yen and the pound, the euro, the New Zealand dollar and the Australian dollar. Traders can effectively borrow at the lower rate in yen and earn interest at the higher rate by depositing in the cross currency of choice. There is no reason for this carry trade not to continue until there’s a change in the interest rate differential, but that change is coming. “I don’t see the U.S. Federal Reserve reducing rates, but I do see the Japanese raising rates. And when traders begin to close out these carry trade positions and take their profits, it could easily drive the yen crosses down 10 or 15 [handles],” he says.

“Selling the euro or the pound against the yen also weakens those currencies against the dollar, and that, in turn, will give overall strength to the dollar,” Trevisani says, adding he sees the USD/JPY at 1.15 and 1.18 towards the end of the year.

Laidi says USD/JPY took out key support areas in August that signal further dollar weakness, adding a rate hike is due by the BoJ in either August or September but could be tabled if the subprime mess causes the yen to strengthen. The USD/JPY dropped below 1.18 in early August making a four-month low.

Trevisani says the Federal Reserve Bank is under no pressure to reduce rates, but Kathy Lien, chief currency strategist at FXCM, says the dollar will continue to get weaker against the yen and the euro for the remainder of the year unless the Fed cuts rates. “The market has already priced in a rate cut by the end of the year, except that the Fed has not changed its tone yet to signal that cut,” she says. “And until it does, the dollar will continue to get weaker.”

STERLING

The sterling has been hitting multi-year highs against the dollar based on falling unemployment in the U.K., and the central bank rate hikes and biases. Hitting $2.0624 in July, the GBP/USD was just below its all-time high of 2.0643.

“Since the sterling had been pressured by increased signs of peaking U.K. home price growth and overall reduction in risk appetite, the main source of renewed gains is seen emerging from the U.S. data front,” Laidi says. A weak showing from the index of U.S. consumer spending and core personal consumption expenditures may push the pound higher, though Laidi says a renewed bull stock market would support the greenback.

Dolan expects the dollar to gain against the high yielding currencies as they reach the peak of their tightening cycles. “I would look for the JPY to continue to strengthen while uncertainty and volatility persists, and the dollar will ultimately perform better than other major currencies on a flight to safety,” Dolan says. “Higher yielding currencies, such as the AUD, NZD and GBP, have the most to lose as traders continue to exit longs in those currencies.”

“There will be a dollar recovery into the end of the year,” concludes Dolan. “It’s going to be an uneven recovery, with strength against European and commodity currencies, and weakness against the Japanese yen, but it’ll move back around 132.00 to 133.00 in the Eurodollar with 1.3850 to 139.00 for the upper limit,” Dolan says.

“The dollar has gone through a major turnaround. When we tested the 80.00 on July 24 in the Dollar Index we saw a pretty sharp rebound in it. Looking at the history of the Dollar Index, there’s no reasonable justification as to why the dollar should suddenly drop out of its 40-year low range that is signified by the 80.00 support.”