Since early 2002, the U.S. dollar has exhibited an accelerating downward spiral against the euro.

Yesterday it hovered around $1.3681 to the euro.

Some of our readers may, even now, be wondering if it is too late to follow many corporations and central banks into a major diversification out of the U.S. dollar and into the euro, especially as the U.S dollar suddenly appeared to strengthen this week.

We offer a few cautionary thoughts for your consideration.

At the outset, the euro should not be confused with the Eurodollar.

A Eurodollar is a U.S. dollar owned by a government, corporation, or individual person who is not subject to American government jurisdiction. In short, it is a U.S. dollar in foreign hands.

As you can imagine, after years of massive U.S. trade deficits, there are a great number of Eurodollars out there. China alone holds about $1 trillion.

The market for Eurodollars is centered in London. The London Inter Bank Offered Rate (LIBOR) is the key market rate, upon which most international loans are based, for dollars around the world. Even within the continental United States, certain loans and financial transactions are geared to LIBOR.

The euro, on the other hand, is the paper currency of the European Union (EU). However, certain EU members, like the United Kingdom, are not members of the so-called "Euro Zone". Unlike the former Deutsche mark, the UK's pound sterling is still a widely held and freely traded currency. Indeed, it is still a reserve currency. As such it has benefited from diversification out of the U.S dollar to a degree that we now see it as overvalued, given its internal forecast inflation rate.

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The euro is now large, very large. Indeed, there are now more euros in circulation than there are U.S. dollars. The European Central Bank (ECB) is based in Frankfurt, Germany. It is headed by Monsieur Jean-Claude Trichet, a Frenchman with a very Germanic, anti-inflation "hawkish" mind-set.

Amazingly and unlike any other international currency, the euro has no single economy upon which it is a call.

In the short-term, the euro is held together solely by the political will of the member governments.

In the medium-term, the single euro interest rate and its increasing price has hurt many of the less "restructured" economies of the European Union. Some prominent politicians in some of these countries (France, Italy and Spain, for instance), have talked openly of leaving the euro. The departure of any major nations from the "Euro Zone" would likely prove catastrophic to such a "political" currency.

For the above reasons, we feel that the euro is, at present, almost a "virtual" currency, on a medium- to long-term time horizon. To that extent, we agree with Morgan Stanley, that the euro is intrinsically flawed, in the long-term.

However, the massive international currency markets tend to have a decidedly short-term view. Each trader thinks that, with such a large, highly liquid market, they could get out, should calamity strike.

Therefore, as a large, alternative "reserve currency," the euro has benefited greatly from and indeed, increased the downward spiral of the U.S. dollar.

In order to increase business, certain "writers" (sellers) of forward option contracts in euros against U.S dollars, offered some "cheaper" (lower premium) contracts. These are commonly known as "knockouts." In order to lower the premium cost of their contracts, sellers put an upside euro limit upon their own risk.

Many so-called knockout contracts have been sold with an upper limit of $1.3700 to the euro. This means that, should the U.S. dollar market price of the euro rise to above $1.3700, a considerable number of $1.37 knockout contracts will become null and void, offering a total loss of premium to the contract buyers.

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The existence of a substantial number of knockout contracts effectively places a considerable resistance level hovering above the U.S. dollar price of the euro in the high $1.3600s.

In addition to this, we hope, interesting market technicality, we feel that there is now a major "interest rate differential" risk in favor of the U.S. dollar.

As our readers will know, we have long felt that our Fed have wanted to hit at a U.S. inflation rate sitting (even according to the officially "cooked" CPI) stubbornly above the Fed's target rate.

We also feel that our Treasury is increasingly concerned about the reserve credibility impact and the inflationary influence of a free-falling U.S. dollar.

In view of their anti-inflationary bias and what we think is their new "unofficial" mandate to support the dollar, we feel that the Fed has been waiting anxiously for some time for an excuse to raise rates, as soon as prudently possible.

We think the Fed has held back because it is fearful of precipitating an economic recession, particularly as the housing bust threatened serious implications for our economic growth.

However, recent indicators, including yesterday's strong ISM (Institute of Supply Management) figures; the fact that income growth appears to be outpacing spending; and that some feel the housing bust may prove to have been overrated, appear to indicate that our economy is in good shape.

We feel that this may lead the Fed to muster the courage needed to do what they basically feel they should do and raise rates on May 9.

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An increase in the Fed rate at this time would shock the bond and stock markets.

It would also shock the currency markets, as the interest rate differential would narrow against the U.S. dollar.

However, we feel the faster moving international currency markets will be less shocked than the bond and stock markets.

The currency markets appear to have already seen this growing risk of an increase in U.S. dollar rates. We believe this is another, more fundamental reason for the dollar's recent strength at the margin.

In light of the above, we urge our readers to be very cautious about expecting continued U.S. dollar weakness in the lead up to the FOMC meetings next week.

Beware, because we feel that any late sellers of the U.S. dollar could be knocked down but not out, at least for a while, if the Fed raises its key rate on May 9.

Today, in light of more bullish talk about the economy and the housing bust (which we feel is merely delayed) we have raised our probability of a Fed rate increase on May 9 from 40 percent to 50 percent.

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