Fundamental Tends

December 4, 2005


Just when it appeared that the forex markets had decided to focus on interest rate differentials as a primary driver for trade, support from that direction may be starting to falter. Another source of dollar demand has been capital flows related to a recycling of petro-dollars and also the Homeland Investment Act (HIA). It has been on the back of these flows that the positive dollar scenario followed by speculative traders has been built. Now the markets are adjusting to the ECB policy tightening on December 1. What matters is not one +25bp rate hike, but what will come subsequently. Our current best guess is that the ECB will engineer a total of three +25 bps rate hikes: one in December and two in 2006, assuming the European economy advances as expected. Now in question is the outlook for Fed policy. It appears now that only two hikes at the next two FOMC meetings are in the bag. Additional, rate hikes might then become increasingly difficult to come by. What the Fed decides to do from a 4.50% platform will be very much determined by the outlook for the economy at that time. This eventual top on Fed Funds might be already starting to put a cap on bond yields. It is just a matter of time until the U.S. yield curve inverts. Thus the outlook for the dollar has become increasingly murky.

EUR/USD: The Eurozone economy is steadily improving, as structural issues have been showing signs of resolution. Central banks have been favoring the EUR for reserve diversification. The German election has been resolved with CDU head Angela Merkel leading a grand coalition. ECB policy has shifted to a tightening mode. The EUR remains the primary USD alternative.

GBP/USD: The GBP has become more vulnerable against the EUR as the U.K. economy has softened. The Bank of England cut rates in August as expected. That was the final cut for a while. The November quarterly inflation report sent mixed messages.

USD/CHF: Swiss forex and monetary policies are tightly entwined. The CHF should remain steady vs. the EUR, and a December monetary policy tightening is assured. The Swiss economy is on an improving track.

USD/JPY: The JPY has been a disappointment as it should be firmer. The September 11 Koizumi election victory favored the reform agenda. Japan also has been dealing with structural issues for the past decade, and the economy is improving. BOJ monetary policy remains on hold, and may shift in 1H06.

AUD/USD: The Australian economy has not cooled by as much as expected, and this has been Aussie supportive. Reserve Bank policy is on hold. Recent data are unlikely to change the steady hand policy of the Reserve Bank.

USD/CAD: Growth in Canada has been steadily improving. The improvement should be supportive of the loonie. The Bank of Canada is expected to hike rates again on December 6. Strong energy prices are a help. An election is due in January.

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