Recently, the US dollar has lost ground against most G10 currencies, including the euro.

Last week, it lost 1.68 percent against the euro despite the ongoing concerns over the Middle East revolts. Usually, fear and uncertainty drive market participants to favor the safety of the US dollar over currencies like the euro.

However, fear isn’t the most important factor driving the US dollar right now, said Marc Chandler, global head of currency strategy at Brown Brothers Harriman. The correlation between the US dollar and fear in the market has trended lower and is now at a 2-year low, according to a study Chandler is currently working on.

The primary driver of the dollar versus the euro is the expected interest rate differentials, he said.

The euro zone has modestly higher inflation than the US. More importantly, the European Central Bank (ECB) is a lot more hawkish than the Federal Reserve.

Prior to the ECB’s policy rate meeting last Thursday, various officials were already giving hawkish sound-bytes to the media. At the meeting itself, ECB President Jean-Claude Trichet was explicit; he vowed “strong vigilance“ over the threat of inflation and said a rate hike is possible at the next policy rate meeting.

Meanwhile, the Federal Reserve indicated that it intends to continue its $600-billion program of quantitative easing and gave no hints about raising interest rates.

This divergence in monetary policy (i.e. the expected rate hike of the ECB) is the key reason for the dollar’s fall against the euro, said Chandler.

A secondary factor is the recycling of ‘petro dollars.’

Recently, the price of crude oil has spiked on fears of unrest in the Middle East, so oil exporters are earning more US dollars.

Their governments, wishing to maintain some fixed ratio of US dollar to other assets in their foreign exchange reserves, are selling off their excess of dollars for other assets, thereby pushing down the dollar’s price.

In the medium term, though, Chandler isn’t so sure that the dollar’s weakness will continue against the euro.

One, the European debt crisis remains unresolved and rising interest rates could exacerbate the problem for periphery members.

Two, Chandler thinks US stimulus policies are very pro-growth. This would drive up earnings for US corporations, which would make the more attractive, which would in turn induce foreign investors to buy US dollars in order to buy stocks in these US corporations. 

Moreover, economic growth should eventually lead the Federal Reserve to raise interest rates and ‘catch up’ with the ECB.

Chandler thinks the events of his forecast may begin to materialize in the second half of 2011. 

In the long term, he is upbeat on the prospects for the US dollar as a global reserve and vehicle currency, as seen in this interview with IBTimes.

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