Wednesday May 19, 2004 - 22:04:59 GMT
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GVI MONTH AHEAD DOLLAR OUTLOOK
The focus of dollar trade remains on Fed policy, and the focus of Fed policy in the minds of traders appears to be shifting away from employment to inflation containment. This shift would presuppose that the improvements in the Employment picture in the U.S. are real and that they will be sustained. The latest obsession of the markets is an expected Fed move to a more neutral policy after the emergency ultra-easy monetary policy engineered by Fed Chairman Greenspan to head off the threat of deflation a couple of years ago. The uncertainty lies in how a measured policy of interest rate increases translates into the fed funds rate in the real world. The markets now have settled comfortably into expectations for a 25bp rate hike on June 30 and then another +25bps on August 10. The scenario then turns a bit murky ahead of the November elections, but then another +50bps are penciled in by yearend for a grand total of +100bps to 2.00% on Fed Funds by the close of the year. As we mentioned last week, the general view is that funds are headed steadily higher to 3-1/2% until the Fed pauses.
On the other side of the ledger, it is public knowledge that the Bank of China intends to diversify its reserve holdings into euros, and while these moves are always made as discretely as possible, there has been some market chatter that they were in buying euros. If the central bank ultimately moves to an exchange rate system based on a basket of currencies, it would make sense to apportion their reserve holdings according to the prospective weights in their currency basket. It is for this reason that the Bank of China is expected to provide ongoing support for the euro as time rolls on. Otherwise, growth in the euro area is seriously lagging Japan and the U.S., and the common currency has little going for it.
Now that the initial dollar short covering phase after the Fed policy shift has run its course, demand has started to wane. Unless overseas investors start to see improving equity prices follow through dollar demand is unlikely to surface and the dollar trades ranges.
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