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Wednesday October 27, 2004 - 13:28:05 GMT

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Forex: Record dollar lows likely

Record dollar lows likely

Given the US current account vulnerability and budget fears, the dollarís long-term trends is likely to be for further depreciation. Assuming a clear result, there is the potential for some relief after the US presidential election, especially with a high number of short dollar positions and the dollar will also be supported by Euro-zone growth fears. Overall, with no great central bank concerns, the Euro is likely to hit marginal new highs ahead of the US election with more decisive record lows around the end of 2004.

Dollar breaks ranges

After a period of calm during the summer with the dollar trapped within narrow ranges against the Euro, the dollar has weakened sharply moving to less than 100 basis points from its record low against the Euro with a high of 1.2840. It has also fallen to near 106.0 against the yen.
Structural vulnerability

The dollarís main vulnerability stems from the widening current account deficit. The deficit this year is likely to be close to 6.0% of GDP and there is little prospect of significant relief next year. Over the first half of the year, the dollar was able to secure substantial support from Asian central bank buying. Asian purchases of Treasuries have weakened as intervention levels have faded, although there may now be fresh buying if the dollar weakens further.

The level of private capital inflows has also fallen due to doubts over the US economy. There was, for example, a net outflow of equity funds in August. This combination will leave the dollar more dependent on short-term capital inflows to finance the deficit. Any decline in inflows would now have a much greater impact in weakening the dollar

Oil prices damaging

The level of oil prices will remain an important factor, especially as prices have traded consistently above the US$50 p/b level over the past few weeks. The high level of energy costs will damage the consumer sector and will also tend to widen the trade deficit.

The doubts over Fed policy have increased this month, especially after a poor employment report. Consumer confidence has also faltered and there is the risk of a downturn in spending.

Political factors

The presidential election will have a significant near-term impact. As we discussed last week, the markets will be relived if there is a clear-cut victory for either candidate, although the markets would also prefer a Bush victory. In the long term, the structural weaknesses are liable to continue whoever wins, especially with doubts over fiscal policy.

Long-term growth optimism

The dollar has some grounds for optimism. In the longer term, there will be scope for optimism over US productivity and growth trends. There are also underlying weaknesses in the Euro-zone and Japanese economies. The Euro-zone, for example, is struggling to raise productivity growth and growth rates have been consistently disappointing. In this context, US growth rates are still likely to be seen as relatively attractive. The Japanese economy is also still finding it very difficult to escape from the deflationary threat and the Bank of Japan will have to maintain a loose monetary policy.

Investment flows

The US Homeland Investment Act will also tend to support the US currency. The more favourable tax rate will encourage investment flows back to the US. Estimates suggest that the inflows could be in the order of US$80-100bn in 2005 which will help offset the current account deficit.

Euro is overbought

The Euro is also overbought on a short-term basis with the number of IMM long Euro contracts still above the 35,000 level. The number of long speculative Euro positions will limit the scope for further dollar selling in the short term.


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