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Saturday February 26, 2005 - 10:48:10 GMT

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Forex: Are dollar fears justified?

The US dollar is likely to remain caught between yield consideration and structural factors in the short term. The Federal Reserve will continue to increase interest rate and a faster pace of tightening can certainly not be ruled out before mid year. The dollar will continue to be undermined by current account fears and fears over a switch out of dollar reserves, especially by Asian central banks. Dollar rallies are likely to be met with heavy selling pressure as central banks lower the percentage of reserves held in dollars. It is also the case that the dollar is likely to need a steady supply favourable news to hold its position and it will be very vulnerable if the data weakens sharply or if the Fed is forced to halt rate increases. This is likely to be a considerable risk over the second half, especially if oil prices remain above the US$50 p/b level. Overall, the dollar is liable to weaken on a six-month view, but depreciation against the Euro may be curbed by wider Asian currency appreciation. There is also still scope for a rally on a 2-3 month view.

Market analysis

The dollar weakened sharply on Tuesday following the US holiday and the US currency dipped to a low of 1.3270 before a slight recovery. There were fresh fears over a switch out of dollar reserves during the week following reports that South Korea will diversify its reserves away from the US dollar. The US currency remains very sensitive to the issue of reserves diversification given the size of the current account deficit. The Korean authorities denied that they would sell dollars, but markets will certainly remain nervous over the issue and medium-term pressures for a switch in reserves out of the dollar will continue. There was a tepid response to the latest US bond auction which will maintain fears over a decline in US Treasury buying by Asian central banks.

It is certainly the case that the accumulation of dollar reserves will be slower. The key issue is that the dollar is likely to be sold on any significant rallies and this will make it difficult for the currency to sustain significant rallies. Asian currency appreciation remain a high risk in the medium term. The US dollar will, therefore, be vulnerable on a trade-weighted basis, but Asian gains would also tend to alleviate pressure for a stronger Euro.

The US economic data was generally close to expectations during the week, The headline consumer price index was slightly below expectations at 0.1%, while the underlying rate was in line with expectations. Fourth-quarter GDP growth was revised up to 3.8% from 3.1% on a revision to exports, while the inflation figures in the GDP report were little changed.

The pace of US interest rate increases will remain an important focus for the US currency. The evidence of the past week suggest that the Fed can still maintain a measured policy and this was the impression given by the minutes for the February meeting. The net risks, however, are skewed slightly towards a more aggressive stance given that underlying inflation fears have increased slightly.

The dollar will continue to draw support from the interest rate considerations, but this support will face a tough battle with the structural weaknesses. Oil prices will also need to be watched closely in the short term following the push in prices back above US$51 p/b. High oil prices will curb demand in the US and there will also be some fears that the Fed will have to consider a pause in rate hikes if energy prices stay strong. The risks of a rate pause will certainly increase over the second half.

The German IFO report was slightly disappointing, but the provisional data suggested that the inflation rate may have increased in February and the ECB remains nervous over inflation, especially with oil prices rising again. Overall, the ECB will not want to cut interest rates, especially with strong money supply growth and some unease over inflation. The Euro-zone current account and capital account data was strong for December, reinforcing underlying support for the Euro.


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