Saturday January 8, 2005 - 11:42:33 GMT
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INVESTICA Ltd - www.investica.co.uk
Yield gap supports dollar
The dollar weakened to a low of 1.3670 against the Euro late in December, but the dollar has strengthened sharply in the first week of 2005, registering the strongest weekly gains for six years. The dollar strengthened to a high of 1.3035 in New York on Friday following the US employment figures.
The economic data releases have generally been close to expectations. The principal release was the payroll report for December and the headline employment increase was slightly below expectations at 157,000 with a dip in retail employment. The November figure was, however, revised up by 25,000 and the unemployment rate was steady at 5.4%. The ISM data for the manufacturing and services sectors were healthy with small monthly increases, although there were some concerns over the employment components, while jobless claims rose strongly in the latest week.
The December Federal Reserve minutes had a significant impact on the market, especially as the central bank expressed greater concern over inflation. There was unease that dollar weakness and relatively high capacity use, coupled with high energy prices, would push up inflation in the economy. Overall, the Fed concluded that interest rates were still too low to keep inflation low even after the December rate increase. The commitment to a rate increase in February was not surprising, but the comments suggest that the central bank will increase the Fed funds rate at the next few meetings and could also consider a 0.5% rate increase in February or March. There is certainly the potential for the Fed funds rate to increase to 3.0% by June. It will be more expensive to short the dollar and there will some inflow of speculative funds.
There will still be serious background concerns over the US structural position and underlying dollar vulnerability will continue given the wide current account deficit. Sentiment has, however, certainly shifted and there will be a greater reluctance to sell the US currency by funds with some evidence of buying. US Treasury Secretary Snow reinforced his commitment to a strong dollar and the comments suggesting that there would be action to curb the budget deficit were potentially significant. Sustained commitment would underpin dollar confidence, but markets will still want action.
Later in the quarter, there will be the potential for fears that higher interest rates could trigger a sharp adjustment in the housing sector and weaken the consumer sector. This combination could expose the dollar to heavy downward pressure, especially as Wall Street would be liable to suffer.
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