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Thursday May 26, 2005 - 13:48:47 GMT

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Is the dollar decline over?

Short-term yield considerations will offer dollar support, especially as the US could well be the only G7 country to raise interest rates on a 3-month view. US growth should also remain firm initially, although the longer-term risks of a sharp slowdown remain high given the very low savings ratio. The Fed may also have to pause the tightening process over the second half of 2005 if consumer demand falters. The dollar will be much more vulnerable if rate increases stall as there could then be an exodus of short-term funds

The dollarís best case for avoiding further depreciation is the weaknesses apparent in other major currency areas, particularly in the Euro-zone. The Slowing UK economy will also underpin the dollar. Asian currency prospects are still generally favourable, especially as China will eventually shift currency policy which will tend to lead to regional currency gains. The US budget and current account deficits will return to haunt the dollar at times and the risk of a dollar collapse should not be ignored. Dollar rallies will also trigger central-bank reserve diversification.

The current dollar rally is more convincing than previous rally attempts and further short-term gains are certainly a realistic possibility. At this stage, however, it still looks to be corrective move rather than signalling a longer-term market turn and the dollarís overall trade-weighted index is still likely to weaken again by the end of 2005. Given the Euroís vulnerabilities it is, however, possible that the gains will be concentrated within Asian currencies and the overall rate of trade-weighted depreciation should also slow.

Dollar rallies

The dollarís gains over the past month have reinforced speculation that the US currency decline seen over the past three years has now been reversed with the dollar seeing its lowest level at the end of 2004. The dollar has rallied to near 1.2550 against the Euro from lows near 1.36 and the dollarís trade-weighted index (TWI) has also rallied. The TWI hit a low of around 80.2 late in 2004 and it has now rallied back to 86.7. From a longer-term perspective, the dollarís recent peak was at 120.2 at the beginning of 2002.

What has changed?

The most obvious factor that has changed over the past few months is the shift in short-term interest rate differentials. 12 months ago, US interest rates were 1% below Euro rates while the premium over yen was only 1.0%. Following eight consecutive interest rate increases from the US Federal Reserve, short-term dollar deposits now yield 1.0% more than Euros while the premium over the yen has widened to near 3.0% and the gap between US and UK rates has narrowed to 1.75%.

The US Federal Reserve is likely to increase interest rates, at least over the two FOMC meetings. Improved short-term interest rate differentials will offer near-term support to the dollar. A tighter US monetary policy, generally will lessen the risk of substantial dollar depreciation. It is, however, important to note that long-term differentials, which are important for longer-term currency trends, have not moved as far and 10-year US Treasury bond yields have fallen back towards 4.0%.

US growth indicators have remained mixed, but fears over a significant slowdown have eased for now following a run of generally favourable data over the past few weeks. The evidence suggests that the economy has rebounded from late in the first quarter, although caution is required given possible seasonal distortions.

The US consumer remains over-stretched and debt levels are very high. The decline in US Treasury yields will provide near-term relief for the housing market and will also help support consumer spending, despite higher short-term rates. Nevertheless, it still looks to be the case that the slowdown in spending has been postponed rather than prevented. Indeed, if there is renewed near-term strength in the housing market, there will be an increasing risk of a longer-term collapse which would also put substantial downward pressure on the dollar.

Relative dollar optimism

Currency values are determined by relative prospects and, in this context, the G7 developments have offered significant support to the dollar. The Euro-zone growth outlook has deteriorated again after brief hints over a recovery while there has been a sharp decline in business confidence. The UK economy has also shown signs of a significant slowdown while Japan is still struggling to escape from deflation. In this environment, the US Federal Reserve could now be the only major central bank to increase interest rates on a three-month view. These relative considerations will offer dollar support.

On seasonal trends, the US currency tends to rally during the second quarter and the dollar is likely to face tougher tests over the second half of the year.

Shift in short-term positioning

The shift in US interest rates will also make it much less attractive to use the dollar as a funding currency. Over the past year, substantial funds have pushed into areas such as oil and commodities with these positions funded through the dollar. The dollar is now much less attractive as a funding currency and these short dollar positions will be reduced or reversed. There is some tentative evidence that this pressure may now have peaked, but nerves will continue over the next few weeks at least

The number of speculative dollar positions has increased sharply over the pat month. Investors will be more willing to hold long positions as there is no longer a cost of carry, but the positioning bias will still hamper a further dollar advance.

Deficits still important

Immediate fears over the US current account position have eased over the past few weeks, helped in part by the improved US March trade data. The latest evidence on imports, however, suggests that the deficit will widen again in April and the underlying current account position will remain precarious over the next few months. The US current account deficit is likely to be at least 6.0% of GDP this year.

There will also be concerns that weak Euro-zone growth and a slowdown in the UK will tend to widen the US trade deficit as US exports will struggle to make strong headway in the face of subdued global demand.

Global investors have been more willing to fund the US deficits, but the sheer scale of the financing requirement will certainly weaken the dollar at times. There is also still the possibility that US currency confidence will weaken sharply if international confidence in the US economy falters, a possibility mentioned by the OECD in its latest report.

The most recent US budget trends have offered some relief, but the longer-term concerns will continue, especially if there is a slowdown in GDP growth.

Asian trends vital

The US is exerting heavy pressure on the Chinese authorities to sanction a Chinese yuan revaluation. Although China could maintain the current peg in the short term and will resist political pressure, change appears inevitable in the medium term. On a 12-month view, the most likely outcome is that Asian currencies in general will strengthen and this will tend to weaken the dollarís trade-weighted value. Stronger Asian currencies would also tend to ease upward pressure on the Euro.

Reserve diversification

The build-up of dollar reserve assets held overseas will remain a major source of concern for the US dollar. Asian currency reserves have increased further over the past year and total close to US$2.5trn while dollar reserves are close to US$1.5trn. Japanís reserves, for example, are around US$850bn while Chinaís reserves have increased to overUS$650bn. The Euroís recent weakness may slow the rate of reserve diversification, but the banks will still be looking to take advantage of dollar rallies to reduce their exposure to the US currency. These pressures should cap dollar rallies.


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