The cost of money is rising not only in the U.S. but around the world, courtesy of global central banks hiking rates to curb inflationary pressures. At the moment, the dollar remains the big winner at the rate-hiking game, but next year it will likely be a different story.

On Thursday, it was the turn of the European Central Bank, which raised its key rate a quarter point to 2.25%, the first such move in five years. Nascent signs of a pickup in economic activity in the eurozone were enough to convince the ECB to move rates higher. The widely expected decision, however, didn't prop up the euro, as ECB president Jean-Claude Trichet downplayed market expectations for further rate hikes.

"We are not engaging ex ante in a series of increases," he told reporters after the ECB decision.

In recent action, the euro was trading at $1.1712 compared with $1.1791 late Wednesday.

The dollar was supported by strong U.S. economic reports, namely the Institute of Supply Management's November manufacturing survey. The ISM index dropped in November but was stronger than economists expected. The survey also showed a pickup in hiring by manufacturers.

Strong U.S. economic data, including Wednesday's news that the GDP grew 4.3% in the third quarter, all but confirmed expectations that the Federal Reserve will continue to lift rates at a measured pace of quarter-point increments.

The Fed is widely expected to hike its key rate to 4.25% on Dec. 13 and to continue hiking in early 2006.

The dollar also rose against the yen, going above 120 yen for the first time in two years. In recent action the dollar was trading at 120.22 yen vs. 119.82 yen Wednesday.

Earlier this year, the Bank of Japan made moves towards abandoning its four-year-old zero-interest-rate policy. But in recent months, and again on Wednesday, the BOJ also downplayed expectations of how quickly it will get there.

Deficit Dilemma

Still, foreign exchange analysts believe that the dollar will, at the very least, hit upside resistance next year. The greenback has been supported in recent weeks as U.S. firms repatriated overseas profits to benefit from tax breaks under the Homeland Investment Act, a provision of the American Jobs Creation Act of 2004. But with the act expiring at the end of the year, these flows will likely subside.

The dollar also remains supported by rising market expectations that the Fed will hike the fed funds rate to 4.75% on March 28. According to Miller Tabak, the market has been pricing in a 54% chance of such a move since Tuesday, when stronger-than-expected reports on consumer sentiment and durable goods were reported, compared to 36% previously.

But this would most likely be the end, or very near the end, of the rate-hike cycle for the Fed. According to Tony Norfield, global currency strategist at ABN AMRO, the money market is increasingly "toying with the view that U.S. rates will peak and could head lower by the end of 2006."

At the same time, risks are tilted for higher rates both in the eurozone and in Japan, despite the rhetoric of ECB and BOJ officials.

Both central banks are facing strong political pressure to not hike rates because growth in their respective regions has remained sluggish. A weak euro and yen help boost exports. Central bankers have therefore tried to dampen expectations of further rate hikes. But they've actually left themselves room to move rates slowly upwards, says David Powell, currency strategist at IDEAglobal.

Notably, Trichet hinted that all options remained on the table by reminding reporters that the ECB, unlike the Fed, monitors headline inflation, which includes energy prices.

"Given that headline inflation at 2.5% remains above the ECB's 2% target, that's a hint that this rate hike isn't the end," Powell says.

Once again, as long as the Fed keeps on lifting rates and positive rate differentials continue to attract foreign inflows into U.S. assets, the dollar will remain supported, Powell says.

The underlying threat stemming from the ever-rising current account deficit, however, may explain why gold has continued to rally even with current dollar strength and tame headline inflation. In recent action, gold was up 1.1% to $504.70 per ounce, on track for its highest close since 1987.

As explained by Peter Grandich here, gold may still be benefiting from a short-squeeze but also from investors' need to hold on to hard assets amid uncertainty about the underpinnings of the U.S. dollar.

Long-term U.S. Treasuries, meanwhile, have continued to benefit from foreign inflows. But on Thursday, the benchmark 10-year Treasury bond was falling 11/32, while its yield rose to 4.53%. The weakness followed the strong ISM report and as the market positioned itself for what's expected to be a strong November jobs report on Friday.

The rise in the yield of the 10-year bond slightly eased concerns that the yield curve, which plots the yields of short-term to long-term bonds, will invert, usually a precursor of economic recessions.

According to Michael Gregory, bond strategist at BMO Nesbitt Burns, there are currently two camps fighting each other in the bond market.

"On the one hand, those that believe that external financing of the current account deficit remain a risk are pushing yields higher," he says. On the other hand, "there are those that think the deficit remains well funded and that the Fed will go too far next year," meaning growth will at least slow.

"My take is that the two will balance out each other and we'll end with a flattish curve," Gregory says.

Stocks, meanwhile, were rallying sharply early Thursday afternoon after profit-taking dominated the first three sessions of the week. In recent trading, the Dow Jones Industrial Average was up 1.1% to 10,929.54, the S&P 500 was up 1.3% to 1265.56 and the Nasdaq Composite was higher by 1.6% to 2268.18.

In corporate news, Limited ( LTD), New York & Co ( NWY) and Gap ( GPS) were higher after each reported better-than-expected chain-store sales Thursday.

U.S. automakers GM ( GM), Ford ( F)and DaimlerChrysler ( DCX) were mixed ahead of reporting November sales.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.

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