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Saturday February 5, 2005 - 12:18:21 GMT

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Dollar confidence - temporary or permanent?

Confidence in the US economy and markets has improved, helped in part by more optimistic comments from Fed Chairman Greenspan and some optimism over action to tackle the US deficits. In this environment, the markets are more prepared to focus on interest rate differentials and this will underpin the US dollar in the short term even though the expectations of a more aggressive Fed monetary policy have faded. The calm financial markets will also help ease immediate fears over US financing difficulties. There will still be longer-term fears over the current account and budget deficits as the structural position is still precarious. There will also be structural Euro buying as central banks will continue to diversify away from the dollar. There is also a risk that the US economy will slow over the second half of 2005 as spending slows. Overall, the dollar is likely to be stable to slightly stronger in the short term as yields offer support, but the currency is likely to face fresh losses on a six-month view.

Market analysis

The dollar retained a firm tone over the week and, after a tough struggle at 1.2940, the US currency strengthened through this level on Friday and reached a high of 1.2860.

As expected, the Federal Reserve increased interest rates by 0.25% to 2.5%, the sixth consecutive 0.25% rate increase. The Fed statement was also in line with expectations. The Fed still considers monetary policy to be accommodative and expects that further rate increases will be required. The inflationary trends will also need to be monitored, especially as recorded productivity growth slowed in the fourth quarter to an annual rate of 0.8%, the slowest growth rate for six years. At this stage, the Fed appears confident that it can maintain a measured tightening stance.

The US employment report was slightly below expectations with a 146,000 January increase compared with expectations of a 190,000 increase while the increase for the previous two months were also revised down slightly by a total of close to 30,000, but the unemployment rate dipped to 5.2% from 5.4%. The steady payroll increase will encourage the Fed to maintain an unchanged policy stance and a further series of 0.25% rate increases at the next few Fed meetings. The other US data was close to expectations, although the ISM manufacturing and services sector indices both recorded a decline over the month. While jobless claims fell to 316,000 in the week and consumer confidence was little changed. US financial markets are likely to look upon the economic prospects as generally favourable in the short term and this should draw funds into the US currency. The yield differentials will also offer near-term support to the US currency. Dollar confidence will also be boosted by US financial-market stability.

There will still be underlying concerns over the budget and current account deficits. Fed Chairman Greenspan chose to make a generally more optimistic assessment of the deficits issue in a speech on Friday, stating that the action to curb the budget deficits, coupled with market action, would help stabilise and start to lower the trade deficit. This provided a boost to financial markets, but investors will also want evidence of action to curb spending and the US budget will be closely watched. The underlying current account position is also still precarious and any faltering of confidence would expose the dollar to renewed and potentially heavy downward pressure.

The Euro-zone data was slightly stronger than expected with the PMI indices for the manufacturing and services sectors both recording a slight advance for January. German industrial orders also rose strongly, but there was a decline in retail sales and the unemployment rate pushed above 5mn due to revised calculation methods.

The ECB left interest rates unchanged at 2.0% and the bank’s comments were mixed. Although the ECB is confidence that inflation will decline to below 2.0%, the ECB is also concerned over the impact of high property prices within the Euro-zone. The most likely outcome is that the bank will keep policy on hold over the next few months. The Euro should still gain underlying support from central bank reserve shifts away from the US currency.


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