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Saturday March 12, 2005 - 12:18:33 GMT

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Dollar faces record lows

Market concerns over the US trade deficit and its implications will continue in the short term with further unease over a potential shortfall in capital inflows. The dollar will be particularly vulnerable if there is definitive evidence of dollar selling by Asian central banks to rebalance their reserves and, in this environment, dollar sentiment will remain fragile. Although the more likely outcome is that banks will slow their dollar buying rather than actively sell the US currency, any shift in flows will increase dollar vulnerability and will certainly limit the potential for US currency rallies. The US growth trends should remain favourable in the short term and short-term US interest rates will continue to rise. There is also the prospect of a further rise in bond yields on inflation fears. Although rising yields will offer some dollar support, the pace of increase will be important as a sharp jump in yields would risk an exodus of overseas funds and trigger Wall Street weakness. The ECB has expressed some concerns over inflation, but a rate increase is unlikely in the short term. Overall, the dollar will remain vulnerable in the short term, with the risk of fresh all-time lows against the Euro, but a second-quarter recovery still looks realistic before selling pressure emerges again.

Market analysis

The dollar remained on the defensive for much of the week and suffered a succession of tests of support around 1.3450 during the second half of the week. There was further selling pressure after the US trade deficit, although the dollar resisted further heavy losses.

The main concerns have surrounded the US trade deficit and the risk that central banks will reduce their dollar holdings. The US trade deficit widened to US$58.3bn in January from a revised US$55.7bn the previous month . The export performance was slightly disappointing despite rising to a record level and, although there was a decline in oil imports, underlying import volume was still very strong. There will be some concerns that the weak dollar is still not curbing US import demand. The trade data will reinforce concerns that the US trade account will remain weak during 2005 and this will leave the dollar remain vulnerable to downward pressure. The size of the deficit will also ensure that markets focus on capital inflows into the US.

The Japanese Prime Minister reported that there should be a diversification of reserves and the markets took this to mean that there would be a reduction in Japanese dollar holdings. The Japanese Finance Ministry was quick to clarify the remarks and state that there would not be dollar selling, but market unease over the situation will continue. There were also reports that the Indian central bank was considering a policy shift and investor unease over the situation will leave the dollar vulnerable, especially with the US running a substantial current account deficit.

The other US data was sparse during the week with an increase in jobless claims. The Federal Reserve's Beige Book reported that the economy was still growing moderately and that inflationary pressure was generally low. There were, however, indications of underlying inflationary pressure with companies facing higher costs and finding it easier to pass on these cost increases. Inflation concerns increased over the week and this will maintain speculation that the Fed will have to tighten policy more quickly.

The most likely outcome is still that the Fed will maintain a measured tightening stance in the short term and announce a 0.25% rate increase for March, although there remains a small possibility that there will be a faster rate of tightening. Growth and interest rate trends will offer dollar support, but the markets will remain nervous over the implications of any overseas selling of US Treasuries. There is the risk of a selling of high-yield currencies as risk aversion rises and this would be likely to offer some dollar support.

The Euro-zone data was limited over the week and most interest surrounded official comments. The remarks from ECB officials still suggested that there are some concerns over inflationary pressure within the bank. ECB Chairman Trichet stated that the bank would be vigilant over inflation and would take action to increase interest rates if necessary. It is, however, very unlikely that the ECB will increase in current circumstances especially with the Euro strengthening.

There is likely to be fresh speculation over intervention to restrain the Euro if there is a fresh surge in the currency. The most likely outcome is that the ECB will decide against formal inflation, although there is certainly the potential for increased verbal intervention.


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