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Wednesday August 10, 2005 - 00:45:33 GMT
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Forex: It's Q4 2004 All Over Again For The Dollar

While it was no surprise that the FOMC would hike the Fed funds rate for the tenth consecutive time today and issue a marginally more upbeat economic assessment, the one salient feature to the currency market today was the inability of the market to find anything in the Fed actions that would encourage dollar buying. The dollar is unwanted. Unwanted in the face of Fed tightening (and more to come). Unwanted in the face of robust GDP (2Q). Unwanted in the face of buoyant jobs data (July). And unwanted in absence of a fundamental theme warranting a lower dollar. Well that is perhaps on the verge of changing.

It helps to think back to late summer and early fall of 2004. At the time
the Fed was tightening and the dollar was starting to weaken. The early
reasoning behind the dollar heaviness was central banks and monetary
authorities juggling reserve this case selling dollars and
buying euros. Coincidentally the same chatter is making the rounds in the
last few weeks. Adding to the notion of reserve managers buying euro/dollar was the yuan revaluation and subsequent, though yet to be defined, link to a= basket of currencies. China for one no longer has the same implied need for buying dollars to maintain a pegged rate. Moreover, one can surmise that the central bank needs more of other currencies in its reserve mix to match the basket weightings. The Middle East, active buyers of euro/dollar in Q4 2004, are again said to be at it...oil fetching record number of dollars demands diversifying the FX exposure.

And the 3-year note auction this week showed a distinct drop off in the
percentage of the overall auction taken down by indirect bidders which is
mostly foreign central banks. Indeed the reserve management story could get even more lift come Weds and Thurs when the respective 5-yr and 10-yr auctions occur and indirect bidding also drops off sharply from tend rates.

Then it is on to Fri when US Jun trade figures are out and any widening in
the trade deficit (not far from record deficit earlier this year), and we
could find ourselves in the throws of a bear market for the dollar with
price action having flushed out a fundamental theme to drive the currency
lower in coming weeks and months. And the report I think is not very
helpful (but who cares if a critical mass thinks otherwise) from US Tsy is
out next Mon showing net long-term capital inflows for Jun. Any drop off
from net flow reported for May could have the effect of driving home the
point of foreign official demand waning for US Treasuries and agencies.

But there is one critical difference with Q4 2004. Things are starting to
look brighter in Germany and Japan. Agreed the fundamentals here are still
inconclusive if not optimistic...more are needed to confirm some scope for
accelerated growth and eventually for Japan and end to deflation. But in
late 2004 there was hardly much positive to say about Europe and Japan.
Indeed of the two I think Japan's chances of accelerating looks more compelling. And the yen is arguably the most undervalued G20 currency at
the moment.

I must confess that I thought the dollar was simply finding a bottom to a
new prolonged range, consolidating significant gains through roughly Jul21
(low and behold when China revalued). But now the risk is rising that the
dollar could find itself about where it was in Q4 2004 with a little help
from US Treasury auction data, Jun trade report and Jun TICS report. Wouldn't it be nice to have something other than a boring sideways summer for the dollar.

David Gilmore


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