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Thursday August 11, 2005 - 13:51:23 GMT

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Has the dollar peaked?

The US dollar should still be able to secure short-term support from growth and yield considerations, especially as the Federal Reserve will continue to increase interest rates. Market expectations over the peak level of rates are liable to edge higher with improved underlying yield support. The dollar will remain vulnerable to underlying selling pressure due to trade deficit fears and central bank reserve diversification away from the US currency. The improved Euro-zone and Japanese economic outlook will also make it more difficult for the dollar to strengthen.

In the short term, the opposing forces should still be close to balance with the dollar underpinned by yield considerations. Despite recent dollar losses, a period of range trading is still realistic with volatility remaining a potentially important feature during August as liquidity will remain low.

The markets have discounted most of the dollar favourable news that is likely to be available and the US currency will find it difficult to make significant gains. It is likely that the trade-weighted index will not be able to push back above July peaks. The US currency will also be very vulnerable if there is any disruption to favourable expectations, especially if the economy starts to falter. Overall, after an interim recovery, the dollar is liable to come under renewed selling pressure during the fourth quarter of the year.

Dollar retreats

After pushing to highs beyond the 1.19 level against the Euro in July, the dollar retreated to 1.2250 later in the month and the loss of support at this level pushed the dollar down to lows of 1.2420 during August. The US currency has also retreated from highs beyond the 1.73 level against the UK currency to around 1.79 and the US currency has also weakened to two-month lows on a trade-weighted index and is close to a six-month low.

Further US rate increases likely

The latest evidence on the US economy has remained generally strong. The manufacturing indicators have pointed to stronger growth with the July ISM index rising to 56.6 from 53.8 the previous month. The spending data has also been firm over the past few weeks with a rebound in retail sales. The latest quarterly report recorded GDP growth of 3.4% for the second quarter of 2005 with a solid expansion in domestic demand. Overall US growth should remain firm in the short term. There has been some evidence of rising wage costs, but the overall evidence suggests that underlying inflation is under reasonable control.

The US Federal Reserve increased interest rates to 3.50% at the August meeting and is likely to announce another 0.25% rate increase in September. There is also no sign at this stage that the Fed is considering a halt in rate increases. Interest rate differentials will, therefore, continue to underpin the US currency in the short term. Euro-zone rates are stuck at 2.0% while Japanese rates are still at close to zero and there has been a cut in UK interest rates. Market expectations over the peak of US interest rates have edged up to above 4.0% with some banks expecting rates of 5.0% next year. Short-term yield differentials will, therefore, offer dollar support.

Markets have discounted good news

The yield spreads on 10-year bonds will be important and the dollarís yield advantage of around 100 basis points over Euros will offer US currency support. Expectations are, however, crucial and the markets have already discounted increases in US short-term interest rates to at least 4.0%. The US currency will, therefore, be vulnerable if the favourable outlook appears to be under threat. The dollar will also find it difficult to make significant headway.

There are major US fundamentals weaknesses and vulnerabilities which should certainly not be ignored and will assume greater important again if yield support appears under threat. The trade deficit showed some signs of stabilisation during the second quarter, but the deficit is liable to widen again for the third quarter and the 2005 current account deficit will be at least 6.0% of GDP. The underlying trade position is, therefore, still precarious. The US budget deficit has narrowed over the past few months with the deficit for the first 10 months of fiscal 2004/05 narrowing to US$302.6bn from US$376.3bn last year, but the progress remains highly dependent on firm GDP growth.

The housing sector is likely to be an important focus, especially as there is growing evidence of a speculative bubble developing. The increase in long and short-term interest rates should help to cool the housing sector gradually, but the risks of a more serious slowdown should certainly not be ignored and a hard landing for the housing sector would cause major damage to the economy.

The latest personal income and spending data recorded that there was a zero savings rate for June, the second lowest rate seen since the depression of the 1930s. The rise in house prices is encouraging a withdrawal of equity and helping to fuel a low level of savings. It is very difficult to reconcile a savings rate at this level with a strong currency. The low savings rate will also make the economy more vulnerable in the event of a downturn in the housing sector. There will be a high risk that spending growth will suddenly slow sharply in response to an increase in higher bond yields or rising unemployment. The near-term risks still appear low, but the medium-term risks are liable to increase and savings will need to rise in the medium term.

Euro sentiment improves

Euro-zone economic sentiment has improved slightly with evidence of a slow recovery in growth while pressure for an ECB interest rate cut has eased considerably. The most recent Japanese economic data has also suggested that the Japanese economy is improving with an improvement in domestic demand. It was much easier to buy the US dollar while there were serious doubts over the other major economies, but recoveries in these economies will complicate the issue. The dollar will have to find more persuasive reasons to secure international buying interest as it will not be able to rely on buying by default.

Longer-term dollar selling

Reserve diversification will be a very important medium-term focus, especially as there will be pressure on central banks to reduce the proportion of reserves held in dollars. This will be particularly important given the change in global currency regimes. There has been a shift in the Chinese currency policy with the authorities moving to a trade-weighted currency basket from a dollar peg. The yuan will, therefore, be managed against the Euro and major Asian currencies as well as the dollar In the medium term, this will lessen the amount of dollars bought by China and it will also increase the pressure for reserves to be held in other major currencies as well as the US currency.

The Russian central bank is also moving to increase the proportion of Euros in the currency basket. There has been evidence of Euro buying by the Russian central bank over the past two weeks and there is also a strong possibility that Asian central banks have also been buying Euros. The central banks were reluctant to add to their Euro holdings above the 1.30 level, but appear to be buying Euros around the 1.20 level.
The high level of oil prices will increase dollar holdings in the Middle East and there is likely to be selling by regional central banks.


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