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Thursday March 10, 2005 - 21:19:08 GMT -

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Fears Of a Wider Trade Deficit Weighs On Dollar

DailyFX Forex Fundamentals 03-10-05

By Kathy Lien, Chief Strategist of

· Fears Of a Wider Trade Deficit Weighs On Dollar
· Japan Keeps Market Guessing On Reserve Policy
· Bank of England Keeps Rates Unchanged


Bulls do not seem to be willing to let go of the euro even as oil prices have finally eased after this past week’s explosive gains. The fear that we could see a pretty bearish US trade deficit report tomorrow is weighing on the dollar. The January rally in the dollar is expected to dent export demand, but the real risk is for a sharp increase in imports from China. There is a great article in yesterday’s NY Times that covers this issue. At the beginning of the year, quotas on textile imports to the US were eliminated. According to the Chinese government, imports to the US from China have surged as much as 75 percent since January 1st. Last year’s trade deficit with China was the largest ever recorded by the US with another country. With the abolishment of these quotas, the deficit should increase even further. Already, we have seen such sharp increases in imports in the first month that tensions are surging in the US manufacturing sector. The NYT article reports that analysts are predicting China’s share of the American market to balloon to 70% from 16% over the next two years. Meanwhile, positive Eurozone economic data is sure to have helped extend the euro’s rally. Germany’s trade surplus was higher than expected in the month of January while French industrial production expanded at a stronger pace. The ECB downgraded both their inflation and growth forecasts, which confirms the ECB’s need to keep monetary policy unchanged for the time being.


Overall the markets have been pretty quiet today as it pauses for a breath ahead of this week’s most important economic release. Today’s economic data was mostly dollar bearish. Jobless claims edged higher from 310k to 317k. Wholesale inventories fell short of expectations, rising only 0.6% while the US budget deficit widened to a record $113.9 bln in February from $96 bln. To the disappointment of traders, the market had actually expected the deficit to narrow. If tomorrow’s trade deficit also widens, it is a clear confirmation that the twin deficits continue to plague the US economy. With oil prices rising, more talk of reserve diversification, and growing deficits, there are many hurdles that the dollar must overcome before bullish sentiment can return for the long haul.


The British pound edged lower as the Bank of England left interest rates unchanged for the seventh straight month at 4.75%. Although there was talk in the markets of a surprise rate hike, economic data released this past week essentially eliminated this possibility. With a wider trade balance, weaker industrial production and disappointing retail sales, the UK government probably wants to wait for a more consistent trend of stronger performance before tightening monetary policy once again. Signs from the housing market have been mixed, which also doesn’t help the case for further hikes. With oil prices back on the rise, the UK would probably like to see how much of an impact oil has on global demand before making changes. It appears that they are very much in a wait and see mode after having raised rates six times since June of last year. The prospect for another rate hike is still likely since the central bank raised its inflation and growth forecasts last month. They expect inflation to rise above their 2% target over the next 2 years.


Talk of reserve diversification hit the wires once again and has been the main catalyst for yen trading throughout the past 24 hours. We have previously said that concerns about reserve diversification will be a major theme in 2005 and the market will be latching onto every word on this topic that comes out of the region. Overnight, while answering questions in front of the House Budget Committee, the Prime Minister of Japan actually said that Japan will need to consider diversifying its reserves. His subordinates immediately rushed in to do damage control for their boss. Both Finance Minister Tanigaki and MoF Watanabe came on the wires to clarify that the government has no intentions of shifting reserves at this time and it would be “unwise to sell dollars” under “current market conditions.” So based upon the developments that have occurred, Japan seems to be playing the same games that the US is playing. On the surface, the Japanese government has been saying that they are not considering changing their reserve allocations, but behind the scenes, there is mounting evidence that this is a major topic of discussion. This sort of artificial solidarity is nothing but an exercise of diplomacy by Asian countries that do not want to cause a major currency crisis. Imagine what could happen to confidence in the dollar if all Asian countries began shifting reserves from dollars to euros or yen on a massive scale – we could easily see USDJPY trading below 95/100 and the EURUSD soaring towards 1.50 in a heartbeat.


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