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Saturday April 24, 2004 - 11:04:14 GMT

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Fed comments boost dollar

The dollar will continue to secure support from optimism over growth and expectations of an increase in interest rates. There will also be little enthusiasm for the Euro given the stuttering recovery. The dollar will, however, find it more difficult to find fresh buying interest as rate hikes are now priced in. The Fed also faces a very difficult task in finding the right strategy to push monetary policy to a more neutral level without destabilising the capital markets or the consumer sector. The dollar fundamentals will remain very fragile, especially with serious economic imbalances. The Euro will also be in a position to secure technical buying support from Euro buying as international central banks rebalance their reserves. The dollar will, therefore, find it difficult to make more than small further gains and is liable to face longer-term depreciation pressure.

The week ahead  

The US GDP figures for the first quarter of 2004 on Thursday will probably receive most attention. Given the concerns over inflation, the deflator figures will also be important.

The US consumer confidence indicators will be released on Tuesday followed by jobless clams data on Thursday. The Chicago PMI index on Friday will be followed by the national figures the next week.

The German IFO index will be released on Monday. Consumer inflation figures on Tuesday will be followed by preliminary Euro-zone figures on Friday.

Market analysis

The dollar strengthened to a high of 1.1785 against the Euro, but still encountered tough resistance in this area and it weakened back towards 1.1950 before a fresh rally attempt to 1.18 on Friday.

The week has been dominated by interest rate expectation, especially with important congressional testimony by Fed Chairman Greenspan. The Fed chief was unusually forthright in his views stating that US pricing power was returning and that the deflation fears were now over. Greenspan also stated that a rate hike may be required, although he gave no specific hints over the timing and was also confident that there were no broad inflationary pressures. Nevertheless, rate expectations have hardened with markets fully pricing in an increase by August. Other comments from Fed officials have confirmed the message over a policy shift, reinforcing suspicions that officials are orchestrating a determined effort to manage market expectations.
The Fed faces a very difficult task in setting interest rates, especially with the added complication of presidential and congressional elections in November. Monetary policy will need to be tightened, but a rapid rate increase in rates would risk severe turbulence in bond and equity markets as well as destabilise the housing sector. There will, therefore, be a temptation to tighten only very cautiously to avoid market turbulence, but this would run the risk of precipitating a harder landing later. The most likely outcome at this stage is for a small rate increase in August and this should be priced into the dollar. Officials will also be very careful to prepare the markets for a tightening, aiming to avoid shocks.

The economic data during the week was neutral with jobless claims only falling to 353,00 in the latest week from 360,000 the previous week. Durable goods orders figures, however, were more impressive with a 3.4% increase for March compared with expectations of a 0.8% increase. The Fed's Beige book was generally optimistic reporting increased activity and a slightly stronger market.

The G7 finance ministers should have an easier task over exchange rates at the current meeting. Currency trends have generally been favourable over the past 2 months and there will also be relief that aggressive Bank of Japan intervention has ended. Comments are likely to be restricted to warnings against volatility which should be neutral for the markets.

The Euro-zone data has continued to give cause for concern with the ZEW index weakening to 49.7 in April from 57.6 in March and this will reinforce market fears over the Euro-zone economy. ECB President Trichet stated that the inflation risks were balanced and the bank will be reluctant to cut rates in the very short term. Next week’s inflation figures are liable to be disappointing, making it more difficult for the Fed to cut rates.

There have been significant longer-term developments with the Chinese central bank confirming that it will aim to diversify its huge level of reserves away from the US dollar. This will involve Euro buying and will provide medium-term Euro support, especially as there will also be buying by the Russian central bank. Asian central banks in general are also liable to curb their dollar holdings.


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