Thursday July 14, 2005 - 14:10:01 GMT
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INVESTICA Ltd - www.investica.co.uk
Dollar resistance likely to increase
The US trends suggest that dollar confidence should remain relatively firm in the short term with the US currency gaining further support from yield considerations. The US structural weaknesses have stabilised for now and the markets will be reluctant to give up on the dollar in the near term, but the underlying situation is still precarious, especially with the current account deficit heading towards 7.0% of GDP. Only a slight deterioration in US fundamentals could spark a substantial shift in sentiment towards the US currency.
The stabilisation in sentiment, together with the potential for central bank Euro buying, will curb selling pressure on the Euro and also suggests that the dollar will see selling interest on renewed rallies beyond 1.20. It is also the case that the markets have priced in favourable developments over the next few months and the US currency will be vulnerable on any setbacks to this optimistic scenario.
The underlying dollar risk profile is liable to increase during the second half of the year, especially if oil prices remain at high levels, and there will be strong selling interest if it appears that US interest rates have peaked. Uncertainty is liable to dominate initially with indecisive movements, especially with lower liquidity. Overall, a period of range trading is realistic in the short term with a still firm dollar bias. The US currency is, however, then likely to come under fresh selling pressure, especially during the fourth quarter of the year.
Questions over the dollar outlook
Following strong gains during June, the dollar is now at an important point against the US currency. The Euro rally from lows below 1.19 against the dollar to 1.2250 will inevitably jolt market confidence in the US currency even though the dollar has since rallied again back to around 1.21.
The US currency was due for a relapse after strong gains since May and the clear-out of long speculative positions could set the scene for renewed dollar gains during the remainder of the third quarter. The markets are, however, likely to pay close attention to near-term trends given that the weakness early this week has revived the underlying dollar fears to some extent.
The overall evidence on the US currency remains mixed. On the positive side, the US will maintain positive yield differentials relative to the Euro. The US Federal Reserve is likely to increase US rates to 3.5% in August and the yield spread on 10-year bonds over German bunds is still fluctuating close to the 90 basis point level.
The US employment data for June was weaker than expected, but the increase was still consistent with firm US growth. Retail sales rose strongly in June with a 1.7% monthly increase. The near-term data will still be important, especially with uncertainty over the impact of high oil prices on consumer and business spending. There will be a small risk of a sudden drop in consumer spending, especially if bond yields are forced higher.
Consumer prices were unchanged in June and the underlying increase was held to 0.1% and the annual core increase fell to 2.0% from 2.2%. The inflation data does not suggest that the Fed needs to tighten interest rates aggressively.
The US trade deficit for May was slightly better than expected at US$55.3bn from US$56.9bn the previous month. Oil prices however, have increased strongly since then and there will be increased fears over the third-quarter trade outlook. The current account deficit is liable to head towards 7.0% of GDP this year, reinforcing the huge demands for foreign capital.
The US trade deficit is slightly less of an issue than it was earlier this year, but there is no room for complacency, especially as recent capital inflows data have been generally disappointing. The budget position has shown some significant improvement this year as tax revenue has increased. The administration ahs cut the fiscal 2005 deficit forecast to US$333bn from US$425bn. Spending levels are, however, still too high for longer-term budget stability and there will be fresh deterioration if the US economy slows. The budget will also be very sensitive to only small changes in GDP growth rates.
Euro sentiment stabilises
Sentiment on the Euro appears to have stabilised even if confidence is still fragile at best. The Euro has also performed better on the crosses over the past two weeks which also suggests that confidence has recovered to some extent. There is evidence of a slightly improved economic performance, notably in Germany, and a slight reduction in pressure for an ECB interest rate cut. The political fears have also eased slightly, although the political and economic vulnerabilities are still evident.
It is potentially very important that there have been reports of central bank Euro buying close to the 1.20 level while the UAE central bank also suggested that it could consider a limited switch into the Euro at the lower levels seen over the past weeks. Structural Euro buying at low levels are likely to offer significant Euro support.
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