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Saturday October 23, 2004 - 11:16:16 GMT

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Forex: Risk of record dollar lows

Concerns over the US economy will continue in the short term, primarily due to speculation that high oil prices will curb spending and increase the trade deficit. The Federal Reserve is still likely to increase interest rates in November, but will find it difficult to justify a move beyond 2.0%. The decline in capital flows and a significant erosion of private inflows will increase underlying dollar vulnerability, especially if Wall Street remains on the defensive. There is a clear risk of momentum selling after the break of dollar support and there will also be the threat of increased commercial dollar hedging. Political uncertainty will make it easier to sell the dollar in the short term, although there is the potential for some rebound after the election assuming that there is a decisive result. The dollar will rally at times, but the underlying trend is for dollar depreciation and there is a 30-40% chance that the US currency will weaken to a new record low this year.

US data releases

Overseas capital inflows US$59.0bn Aug (US$63.1bn Jul)
Consumer prices +0.2% Sep (+0.1% Aug)
Philadelphia Fed index +28.5 Oct (+13.5 Sep)
Jobless claims 329,000 week ending Oct 16th (354,000 prev)

Market analysis

The dollar has remained on the defensive over the past week, undermined by a deterioration in confidence and growing bearish sentiment. The dollar weakened to a low of 1.2650 on two occasions and support here was under major threat in New York on Friday with a decline to 1.2680.

The dollar was undermined by capital inflows data which recorded a slowdown in inflows to US$59.0bn from US$63.0bn the previous month. Although capital inflows still covered the trade deficit, the margins have narrowed sharply over the past few months. Early in 2004, inflows were twice the size of the deficit, but the August figure was only 1.1 times the monthly trade shortfall. The composition of inflows was also worrying as there were equity outflows and a sharp decline in private bond inflows. This will leave the dollar increasingly dependent on official capital inflows. There has been evidence of increased institutional dollar sales over the past week and the move above EUR1.25/US$ will increase the risk that commercial hedging will increase again. Markets will also speculate over a repeat of 2003 when the dollar fell sharply during the fourth quarter. This is likely to reinforce negative sentiment and there is a greater risk of rapid US currency losses and record lows against the Euro before year end.

The headline inflation figure was in line with expectations at 0.2%, although there was a 0.3% increase in underlying expectations due to a sharp increase in living costs. The higher underlying inflation will maintain some pressure for a tighter monetary policy and there is still likely to be a Fed rate increase for November. The difficulty for the dollar is that it will be increasingly difficult for the Fed to justify further rate increases beyond November, especially if oil prices remain high.

The presidential election will have a short-term impact, with uncertainty likely to unsettle the US currency unless Bush can open-up an opinion poll lead of at least 5%. If there is a Republican victory, the dollar would be likely to rebound in the short term. There would still be longer-term doubts over fiscal policies and sustained dollar strength appears unlikely.

The comments from ECB officials suggests that the central bank is comfortable with a firm Euro as it will curb inflationary pressure generated by high oil prices. The ECB will not want disorderly markets, but there is unlikely to be major near-term opposition to gradual Euro gains. The US administration will voice support for a strong currency, but there is no real chance of intervention. This will increase the dollarís near-term risk profile. The Euro will, however, still be restrained by the fact that there are a high number of long speculative Euro positions and a sharp correction cannot be ruled out.


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