Wednesday May 12, 2004 - 17:30:10 GMT
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GVI- MONTH AHEAD DOLLAR OUTLOOK
The focus of dollar trade remains on Fed policy. U.S. monetary policy is also the dominant factor for virtually all financial markets around the globe: stocks, bonds, forex and commodities. The Fed policy statement released over a week ago lifted a lot of the haze surrounding its intentions. A “measured” policy tightening implies gradual rate increases, but did not tie the central bank to any specific road map. The stronger than expected April U.S. employment report is generally perceived by the markets as having influenced that road map of the Fed. The focus is not so much on whether the FOMC will tighten on August 10 or June 30, the markets place 90% odds on a June 30 rate hike, but it is the expected pace of subsequent tightening moves that is driving global financial markets. They assume that the most recent pace of job creation will be sustained and pricing in monetary neutrality (3-1/2% Fed Funds) within the next two years. The immediate impact of this forecast has been to force many to unwind dollar carry trades, where market participants had been using cheap dollars to finance positions of all types ranging from stocks to bonds, forex and commodity market positions. This adjustment has led to turmoil in the markets and generated short-covering demand for dollars.
Once this short covering phase has run its course, demand for the dollar could start to wane unless overseas investors see reasons to move into dollars. Rising bond yields could certainly help, but short rates at or around current levels are not terribly enticing. Also, improving equity prices could help, but with corporate profits already at peak levels, stock prices probably do not have much upside left. Perhaps the stock prices may have to trade lower before they draw in capital again. One other impetus for dollar demand could be weakness in the equity markets overseas. Unlike many other countries, the U.S. has a chronic Current Account hole that it must constantly refill. Our bottom line is that the dollar upside beyond temporary short-covering demand could be limited.
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