US dollar rallied to multi-month highs versus major currencies in the past week on shifting growth and interest rate expectations. While the US slowdown or even recession has already been priced in, investors seemed unprepared by the barrage of negative economic reports out of other industrial countries. GDP in Japan and the euro region contracted 0.6% and 0.2% quarter-on-quarter in Q2, and the Bank of England, in its Quarterly Inflation Report, also said that UK GDP could be negative for one or two quarters. With recession risks rising, the European Central Bank, the BOE and other central banks have turned more dovish, leading to expectations that interest rates in these countries would be cut sooner rather than later. In contrast, the US Fed was the first to cut and has already lowered rates by 325 bps since August 2007. Market reckons that the Fed might be done easing and its next move could well be a rate hike.

Apart from a dramatic shift in interest rate expectations, dollar sentiment has been underpinned by a sharp fall in crude oil prices. After hitting a historical peak of USD147.27 a barrel on July 11, the price of crude has declined about 20%. In the event, the dollar scored its biggest rally against majors in many years, rising to six-month highs against the euro and multi-month peaks versus other currencies. The euro is now 8.5% below a record high of 1.6038 reached on July 15. Among the majors, the British pound was the worst performer, trading near 21-month lows against the greenback after the BOE's warning on growth.

Over the past week, the dollar has strengthened over 1% against the euro and about 3% versus the British pound. Looking ahead, with more evidence pointing to a global slowdown and more central banks forced to reduce rates, the dollar rally could well persist.

Two weeks could be a long time in financial markets. Just over two weeks ago, market was undecided about the global interest rate outlook. With inflation rising on the back of a sharp jump in oil prices in the past year, and with the economy in many industrial countries, with the exception of the US, growing at a steady pace, many central banks are expected to maintain a hawkish stance, or at best, keep their interest rates steady.

However, as events unfolded in the past fortnight, sentiment has turned sour. Japan and the euro zone released negative GDP numbers for Q2; the UK housing and labour markets showed signs of further deterioration; business confidence turned more negative in Australia and house prices continued to fall in New Zealand.

Central banks too, are becoming less optimistic. After the ECB's regular policy meeting on August 7, ECB President Jean-Claude Trichet pointed to a slowing in euro zone GDP growth in the second half of 2008. The BOE also warned of downside growth risks in the UK in its Quarterly Inflation Report released on August 13. At the same time, Australia's central bank projected slower growth ahead. The sequence of events indicates that central banks may be willing to reduce rates sooner than expected.

Although the threat of inflation has receded somewhat after the recent decline in oil prices, down more than 20% after hitting a historical peak of USD147.27 a barrel on July 11, we reckon that central banks would still be wary of cutting interest rates early. We expect the BOE to start taking easing action sometime in Q1 of 2009 and the ECB to wait until Q2 before easing rates. New Zealand is in a more dire state and therefore the Reserve Bank of New Zealand may start to cut rates before the year end.

Click here to download full report.