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Thursday January 26, 2006 - 15:38:16 GMT

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Where next for the dollar?

US interest rates are likely to peak in the first quarter of 2006, potentially as early as January. The ECB is unlikely to adopt an aggressive tightening policy, but there is the potential for interest rates to be increased steadily during 2006. The dollarís yield advantage is likely to narrow significantly which will provide background Euro support even though nominal US interest rates will remain higher.

There will be further unease over the US trade deficit with the current account position unsustainable deficit and the dollar will be more vulnerable now that capital repatriation has effectively ended. There will also be persistent unease over the risk of central bank reserve diversification away from the US currency.

The net dollar risks are likely to be higher during 2006 and an important feature could be increased volatility, especially with uncertainty triggered by the new Federal Reserve chairman taking office at the end of January. The net risks suggest that the dollar will weaken at a measured pace during 2006.

A benign scenario is certainly plausible with a gradual slowdown US housing sector and still firm growth overall allowing a gradual dollar depreciation within recent ranges. There is, however, also the possibility of rapid dollar losses as confidence deteriorates, especially if the Fed misjudges monetary policy.

Dollar stumbles early in 2006

The dollar has weakened significantly during January 2006 with losses to just beyond 1.23 against the Euro from 1.18 in late December, reversing part of the gains seen during 2005. The dollar is now at a potentially important crossroads, especially with speculation over a turning point in the global interest rate trends.

Interest rate policy in focus

Interest rates will inevitably remain a very important focus for the markets in the short term and will play a pivotal role for the US currency during 2006.

The US Federal Reserve increased interest rates at every 2005 FOMC meeting, but the 2006 outlook is much less certain. The economy is still recording firm growth, but there have been signs of a slowdown, especially in the housing sector. Sales have weakened and there is evidence of reduced speculative housing buying. Growth in the wider economy is still firm despite a probable slowdown in the fourth quarter of 2005. The employment market remains strong which will underpin confidence, but there is still likely to be a slowdown in consumer spending. The most likely outcome is that the housing market will weaken gradually which would lessen the risk of a rapid slowdown in the wider economy. A rapid housing reversal would present much bigger dangers to the US economy.

As far as inflation is concerned, there was a surprise drop in headline December prices as energy prices continued to fall while core prices rose 0.2%. There have been steady monthly increases in underlying prices with a core increase of 2.2% for 2005 as a whole. The lack of movement in core inflation will offer reassurance, but the Fed will remain on high alert, especially as oil prices have increased again.

The full effect of higher short-term interest rates will not be felt until the second half of 2006 and the Fed will, therefore, need to be very careful not to tighten too aggressively from now on. Inflation concerns have eased slightly over the past few weeks, but the Fed will remain on high alert, especially with a renewed increase in energy prices over the past few weeks.

Tough task for Fed Chairman

The new Fed Chairman will take office at the end of January and Ben Bernanke will want to maintain policy stability. Bernanke will also be reluctant to take a soft stance on inflation early in his tenure and there will, therefore, be a reluctance to stop interest rate increases as soon as he takes office. Any perception that the Fed was taking a soft stance on interest rates could undermine confidence in his inflation-fighting credentials and destabilise dollar confidence. It is also the case that it is very difficult to regain confidence once it has been lost. There will, therefore, be a temptation to tighten interest rates again in March to reinforce the Fedís inflation-fighting credentials.

The equation will, however, be very different in March if the economy is slowing significantly as the markets would be looking for interest rates to peak. Ironically, Bernanke is liable to face one of his toughest tests at the start of his tenure. There is a very high probability of an interest rate increase at the January 31 meeting. A further increase in March should certainly not be discounted, but there is at least a 50% chance that rates will be left at 4.50%. Rates should be unchanged during the second quarter.

As far as dollar policy is concerned, the Fed will be broadly happy to take a free-market approach to the US currency, but Bernanke will need to avoid saying this, especially if the dollar starts to weaken.

Trade will remain important

As the monetary cycle turns to be less favourable for the US currency, attention will tend to focus more on the US trade deficit. The deficit narrowed slightly in November to US$64.2bn from a record October shortfall of US$68.1bn as lower oil prices helped curb the import bill. Export shipments were also boosted by an ending of the Boeing strike, but the 2005 shortfall will still have been a record and close to US$50bn above the 2004 level.

The export performance offers some encouragement, but a substantial narrowing of the trade gap is unlikely during 2006. A sharp weakening in US growth would cut the deficit, but a reduction in these circumstances would be unlikely to offer significant dollar support.

End of repatriation flows

The US dollar secured important support during 2005 from a repatriation of capital as the homeland investment act sanctioned a reduced tax rate on profit repatriation by US companies. The tax break effectively ended at the end of 2005 and there will, therefore, be significantly reduced dollar support during 2006.

The overall capital account will therefore be weaker, increasing the demands for short-term capital inflows. The capital account data for November remained encouraging with net inflows above US$80bn which will provide short-term reassurance.

Reserves policies will remain in focus

During 2005, there was a further build up of dollar reserves held by global central banks and there has been further intervention early in 2006 by Asian central banks to curb local currency gains. Chinaís reserves for example were close to US$820bn at the end of 2005. There will be further speculation that central banks will look to diversity these reserves away from the dollar during 2006.

There will be pressure to reduce the dollar proportion of reserves to reflect more closely the currency regimes. China for example has confirmed that the dollar has a weighting of less than 50% in the yuan currency basket and this will reduce the attractiveness of holding the bulk of reserves in the dollar. There will also be further pressure to increases investment returns on reserves.

Given the sensitivity to returns, this risk of a move away from the US currency will increase once it appears that the US interest rate cycle has peaked.

Euro-zone improvement

The ECB increased interest rates by 0.25% to 2.25% in December, the first increase for five years. The Euro-zone data generally has shown a significant improvement over the past few months with evidence of some acceleration from late in 2005. There has been particularly strong evidence of an improvement in the key German economy with strong gains in business and consumer confidence which has triggered growth in retail sales. Demand indicators elsewhere are still patchy, but the overall evidence will boost confidence at the ECB.

Firm ECB stance likely

Headline inflation will remain above the 2.0% target level in the short term and, although the underlying inflation rate should remain under control, the central bank will be particularly keen to prevent increased inflation expectations becoming entrenched in the economy or markets.

The central bank considers that policy is still accommodative at current interest rates and there are likely to be further increases during 2006, potentially taking rates to 3.0% by the end of the year unless there are any major external shocks.

The most likely outcome is that there will be a significant narrowing of the short-term yield gap between the Euro and dollar, although the US currency will retain an advantage.


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