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Friday November 18, 2005 - 12:43:20 GMT

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Where next for the dollar?

Dollar confidence will remain strong in the short term with the currency supported by yield considerations. The US Federal Reserve will tighten policy again in December, reinforcing the dollarís yield advantage. The greater confidence has also been illustrated by strong capital inflows and there is also the potential for momentum dollar buying.

A substantial amount of favourable US news has already been discounted, however, and the dollar will now be very vulnerable on only a relatively small shift in sentiment. Growth is likely to slow as the housing sector is hurt by rising interest rates and rate expectations are likely to fade. Over the next few months, the ECB is also likely to tighten monetary policy which will lessen dollar buying interest.

The US external deficits have been financed comfortably during the past few months, but complacency over the situation would be very dangerous, especially in view of the very low savings ratio. The 2005 specific dollar support of capital repatriation will be missing during 2006 and reserve diversification away from the US currency will remain a persistent risk.

Overall, the dollar is likely to peak against the Euro before the end of 2005 and is likely to weaken during 2006 as a whole. At this stage, dollar losses are likely to be measured.

Dollar gains ground

The dollar has consistently strengthened following the short-term downward pressure seen after hurricane Katrina in late August. During November, the dollar has strengthened to around 1.1650 against the Euro, the strongest level since December 2003, and has also strengthened to near 120.0 against the yen before a slight corrective retreat.

US confidence improves

The latest capital account figures have reinforced the fact that international confidence in the US economy and currency has improved. In September, for example, the US attracted over US$100bn in inward investment. There were strong purchases of equities and bonds by overseas private sector investors with a particular interest in corporate bonds. This was offset by the fact that official buying of US assets was much reduced for the month. There will still be the risk of a renewed loss of confidence in the economy if the fundamentals start to deteriorate and the most recent data has suggested that equity flows into the US have weakened again. In this context, confidence remains the crucial ingredient.

Is growth sustainable?

The latest evidence on the US economy has remained generally strong despite the economic disruption caused by the hurricanes. The manufacturing indicators have pointed to stronger growth with the November ISM index staying close to the 60.0 level while the services sector index rebounded for the month. Retail sales growth has been dented by falling auto sales, but there have still seen significant gains. The latest quarterly report recorded GDP growth of over 3.0% for the third quarter of 2005 with a solid expansion in domestic demand. Although the November employment increase was below expectations, the jobless claims data has remained favourable.

The firm labour-market indicators will help support spending, but there was a 1.6% annual decline in real earnings for October. The housing sector is likely to be an important focus and it will be much more difficult to maintain spending levels once the housing sector slows, especially as equity release from the sector has provided crucial support for spending and the US economy during 2005. The latest evidence suggests a slight reduction in demand within the sector and the increase in long and short-term interest rates should help to cool the housing sector at a measured pace. The risks of a more serious slowdown should certainly not be ignored and such a deterioration could cause major damage to the economy. Even if major damage is avoided, the contribution to growth from the housing sector is likely to be much weaker during 2006.

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.

Further US rate increases likely

The US Federal Reserve increased interest rates to 4.00% at the November meeting and is likely to announce another 0.25% rate increase in December. 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 at 2.0% while Japanese rates are still at zero. Market expectations over the peak of US interest rates have edged up to around, and in some cases, above 5.0%. Short-term yield differentials will, therefore, offer further near-term dollar support.

Ben Bernanke is due to take over the Federal Reserve chairmanship from the end of January. The indications are that Bernanke will not change policy radically in the short term and there will be optimism over continuity following Greenspan.

He is, however, likely to push for an inflation target which could spark friction with Congress. He is also likely to respond quickly with lower interest rates if there appears to be a threat of deflation within the economy. The longer-term dollar risks are liable to be slightly higher under Bernanke

Markets have discounted good news

The yield spreads on 10-year bonds will be important and the dollarís yield advantage of close to 100 basis points over Euros will offer further near-term US currency support. Expectations are, however, crucial and the markets have already discounted a rise in US short-term interest rates to at least 4.5%. The US currency will, therefore, be vulnerable if the favourable outlook and rate increases appear to be under threat. Yield spreads have also narrowed slightly over the past week.

There are major US fundamentals weaknesses and vulnerabilities which should certainly not be ignored. Structural factors will assume greater importance again if yield support appears under threat. The trade deficit has widened in the third quarter, although this primarily reflected the jump in oil import costs. The 2005 current account deficit will be at least 6.5% of GDP and the underlying balance of payments position is, therefore, still precarious, especially as the evidence suggest that direct investment flows have remained weak.

Euro sentiment improves

Euro-zone economic sentiment has improved slightly with evidence of a slow recovery in growth. The ECB has become increasingly concerned over the inflation outlook as the headline rate has been consistently above the 2.0% rate. Although the underlying rate is still under control at 1.4%, there has been increased alarm within the ECB while the European Commission has also revised inflation forecasts higher. There is at least a 50% chance that the ECB will increase interest rates in December and, even if rates are left on hold, an increase is highly likely in the first quarter of 2006.

Longer-term dollar selling

Reserve diversification will be a very important medium-term focus, especially as there will be underlying 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. The Chinese yuan will increasingly 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.

Dollar rallies will be seen as providing attractive opportunities to reduce dollar holdings by global central banks.

End of capital repatriation

The dollar has secured consistent support during 2005 from the repatriation of funds to the US, triggered by the lower tax rate under the Homeland Investment Act. This concession will close at the end of 2005, lessening capital flows back to the US, and there is also evidence that may companies will look to complete the operation before the end of November. The flows will offer near-term dollar support, but the dollar will be more vulnerable to selling pressure from December.


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