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Thursday May 12, 2005 - 13:46:25 GMT

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Where next for the dollar?

The US data released during May has offered significant dollar encouragement with strong employment growth a jump in retail sales and a sharp drop in the trade deficit. This combination will ease fears over a slowdown in growth and also offer some optimism that the deficits are starting to narrow.

There are, however, still substantial longer-term risks for the US economy and currency. The balance of payments position will remain precarious, even with any slight narrowing of the trade deficit, and the data improvement may not be sustained. Growth is still likely to weaken over the second half, possibly sharply.

The net risks suggest that the dollar will still need to depreciate on a trade-weighted basis over the next few months. The Fed tightening will certainly tend to slow and limit the dollar’s decline. Any measures to let Asian currencies strengthen, primarily focussed on the Chinese yuan, would allow the dollar to depreciate gradually without putting fresh upward pressure on the Euro.

Overall, the dollar is still like to face very strong barriers to strengthening significantly from current levels against the Euro. Although a move to 1.25 should not be ruled out, the dollar is likely to weaken over the second half. There is, however, also a reduced risk of a dollar slide through the 1.40 level against the Euro this year.

US currency secures relief

After sliding to 1.36 against the Euro at the end of 2004, the dollar has rallied and, despite intermittent selling pressure, the currency has strengthened to beyond 1.28 against the Euro and is challenging important resistance around 1.27. The dollar is now at an important levels and there will be some speculation that it is set for further gains.

Tough battle on fundamentals

The overall forces on the dollar and Euro are still close to balance at this point. The pattern of a weak US structural position and wide current account deficit is in contrast to the strong balance of payments position for the Euro-zone. The US growth advantage, however, is in strong contrast to weak conditions in the Euro-zone while short-term yield differentials will continue to move in the dollar’s favour. While this uneasy equilibrium continues, there could be relatively limited dollar movement. If US growth weakens, there will be a greater risk that the dollar’s structural difficulties will be the most important factor and this would tend to weaken the dollar. A combination of stronger US growth and narrowing trade deficit would, however offer significant dollar support as it would put the focus back on weak Euro-zone growth.

In this context, the March US trade data offered dollar support with the monthly deficit sharply lower than expected at US$55.0bn from US$60.6bn the previous month. The data will ease immediate trade concerns, but there may be some problem with the seasonal adjustment and there will be a risk that the deficit will jump next month. The overall trend is still for a wider deficit with the first-quarter deficit US$30bn higher than last year. The current account deficit is likely to be able 6% of GDP this year and this will still pose considerable dollar risks.

The economic data released during April suggested a possible slowdown in the economy with poor figures on retail sales and durable goods orders. The mood of gloom was lifted by the employment report released at the beginning of May which recorded a much stronger than expected payroll increase of 278,000. The weekly jobless claims data has, however, been broadly static and this suggests that the April employment increase may have been overstated.

There will be further concerns that consumer spending will weaken over the next few months under the impact of high oil prices, high debt levels and rising interest rates. The savings rate is also very low which leaves the consumer sector very vulnerable to any income shocks. The April retail sales data eased the short-term fears over consumer spending with a 1.4% monthly increase.

Fed will continue to tighten

The inflation concerns will persist in the short term, especially after strong inflation data reported in April when the underlying consumer price monthly increase rose to 0.4%. The Federal Reserve increased interest rates by 0.25% to 3.0% at the beginning of May, maintaining the pattern of recent Fed meetings, and this was the eighth successive increase since last June. The Fed will be concerned over inflation, but the US central bank will aim to maintain a measured policy and 0.25% rate increases are likely to continue in the short term.

The short-term yield differential over Euros, now at 1.0%, will therefore continue to edge in the dollar’s favour, especially as the Euro-zone growth data is likely to remain weak in the short term.

Other factors to consider

• The dollar will remain vulnerable to reserve diversification over the next few months. Asian central banks are uncomfortable with the large build up of dollar reserves seen over the past two years and will look for opportunities to reduce their dollar holdings or at least slow the purchase of new Treasuries. This will be a particular risk for the smaller Asian central banks.

• The US is still in a position to see a repatriation of corporate funds held overseas during 2005 after the lowering of tax rates for this year. This will be positive for the US dollar, but the level of dollar buying is likely to be less than US$50bn.

• The budget trends have received relatively little market attention over the past two months, but the deficit will remain a very important issue, especially as it will tend to widen if there is a slowdown in tax revenue. The already wide deficit will also limit the potential for extra spending to cushion any economic downturn. In this context, the better than expected March figure will offer some near-term dollar encouragement.

• The increase in US interest rates will discourage carry trades financed through the dollar and this will increase the potential for a flow of short-term funds back into the US currency.

• There is, however, also the possibility of financial stresses within a major US financial institution as US interest rates increase. Any significant financial stresses would be likely to weaken the dollar on rising risk aversion.

• Asian currency polices will remain important with continuing pressure for a yuan revaluation. If Asian currencies do strengthen, there will be the risk of general downward pressure on the US currency. The net appreciation pressures on the Euro would, however, ease as the dollar trade-weighted depreciation would take place against the Asian currencies rather than the Euro. The net risks suggest that the Euro would not gain significantly.

• The Euro-zone economy remains weak and there is little short-term prospect of a significant near-term recovery. The ECB wants to raise interest rates as it considers rates too low for long-term stability, but the economic conditions are liable to block any short-term move to push rates above 2.0%.

• The French EU constitution referendum at the end of May will be significant. The yes vote has recovered to some extent over the past 2-3 weeks and the most likely outcome is that political fears will ease with a narrow approval realistic. A no vote would hurt the Euro, but the major damage would probably be seen in emerging-European currencies.

• The dollar is following the same pattern against the Euro seen last year and, after holding steady during the next 2-3 months, there will be fears of renewed losses during the fourth quarter.


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