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Monday January 24, 2005 - 22:26:08 GMT
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Dollar Risks Losing To Euro As Dominant Reserve Currency

DailyFX Forex Fundamentals 01-24-05

By Kathy Lien, Chief Strategist of www.dailyfx.com

- Dollar Risks Losing To Euro As Dominant Reserve Currency
- Snow and Eichel Suggests No Major Changes To G7 Language
- BoE Expects House Prices To Continue to Fall

EURUSD

The biggest chatter in the markets today is about the article in the Financial Times that talks about the shifting of central bank reserve positions from dollars to euros. This is something that we have warned about for some time now in previous editions of Daily Fundamentals as well as in our 2005 currency outlook. Russia has already announced their intentions to shift their mix of reserve allocations. The central banks of oil exporters in the Middle East have also reduced their dollar holdings over the past 3 years. According to the report, 90 percent of central bank portfolio managers surveyed said that the income from reserve management was important to them. The decline in the dollar not only reduces the yield that they receive, it can also result in negative real returns if the depreciation of the dollar causes their investments in US Treasuries to be converted back to their local currency at a lesser value than the yield earned. However protecting profitability is not the only reason for central banks to change their mix of reserve holdings. With confidence growing in the euro, central bankers will need to hedge trade exposure more appropriately. As the currency for 12 countries, the euro is becoming a more predominant player in foreign trade. Although the euro has given back all the gains it incurred following the printing of the FT article, this is a trend that the market needs to pay very close attention to. We are sure that it will fall back to sidelines like it has since late last year, however this should be a factor that continues to favor the euro for the foreseeable future.

USDCHF

Although the dollar ended the day unchanged against the Swiss franc and the euro, we continue to believe that we have probably seen the end to the dollar’s extensive rally for the time being. This week’s economic data is not expected to be supportive for the dollar, with the recent ABC and University of Michigan consumer confidence surveys suggesting that we should start the week off on a sour note as the Conference Board consumer confidence survey is expected to echo the deteriorating sentiment reported by the two prior surveys. At the end of the week, GDP data will confirm that growth has slowed in the fourth quarter. The pickup in heating demand due to the blizzard conditions in the Northeast has sent oil prices back towards $50 a barrel, which is also dampening prospects for the greenback. Focus continues to center on the FOMC and G7 meetings next week. However, judging from recent developments and comments, all this speculation will probably lead to nothing. The Fed could very well keep the FOMC statement unchanged for another month following the tame inflation reports. With growth expected to slow in China and the country already taking measures to open up their financial markets to the international community, the government could have justification for delaying revaluation. In an interview with CNBC today, Snow said that he “wouldn’t anticipate any change” in the G7 language. This follows similar comments by Germany’s Eichel this morning.

GBPUSD

The British pound rallied against the dollar despite warnings from Bank of England member Kate Barker that house prices are more likely to continue to fall than rise this year. Last week, the improvement in the RICS house price balance brought on some speculation that the housing market may have bottomed. Barker said that, “past experience suggests that house-price movements in one direction over a quarter are more often than not followed by a further change in the same direction. With clear signs that the UK economy is slowing, the housing market continues to remain one the central bank’s major areas of concern. However, it is not their only one. According to Barker, the slide in the dollar and private sector productivity are also important.

USDJPY

After hitting a high of 103.92 on Friday, the yen has once again regained strength against the dollar. The release of the minutes from the Dec 16-17 monetary policy meeting has spurred modest optimism that the Bank of Japan may be closer to raising rates than the market may have initially expected. According to the minutes, two of the board members proposed lowering the daily target current account balance, which could have been perceived as a slight removal of easier monetary policy. Although all members eventually voted unanimously to keep the liquidity target unchanged, the Bank of Japan’s goal of quantitative easing may be achieved sooner rather than later.

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