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Forex: Dollar Slides as Pressure Increases on China to Revalue– Will it Matter?

DailyFX Fundamentals 04-24-06

By Kathy Lien Chief Strategist of www.dailyfx.com

- Dollar Slides as Pressure Increases on China to Revalue– Will it Matter?
- More Central Banks Talk of Diversifying to Euro
- G7 Meeting Could Pave Way for US to Brand China as Currency Manipulator

US Dollar

The US dollar succumbed to selling pressure today as the G7 harshened its stance on China, calling for exchange rate flexibility specifically from the Asian giant. This is eerily reminiscent of the 2003 G7 meeting in Dubai. If you recall, back in 2003, the G7 finance ministers called for “more flexibility in exchange rates.” At that time, the change to the statement was the first significant move by the committee in 3 years. It resulted in a 150 pip knee-jerk rally in the EUR/USD, but over the next four months, the dollar fell another 11 percent against the Euro (which amounted to 1100 pips), 9 percent against the British pound and 7 percent against the Japanese Yen. The long term impact was far more substantial than the market’s knee jerk reaction, which is the risk that the market faces today. Over the weekend, we had another major shift to the G7 statement. For the very first time ever, China has been mentioned directly by the G7, reflecting their increased concern over the past few months. This also raises the question of whether the US Treasury’s FX report due in two weeks would also brand China as a currency manipulator. The G7 report could have paved the way for the Treasury to also take a harsher stance which given the G7 statement, would probably have less of an impact on the market. More importantly, the G7 statement is basically advocating appreciation in the Asian currencies and as a byproduct, depreciation in the US dollar. This is a key point since it comes at a pretty important juncture. The Federal Reserve is nearing the end of its tightening cycle while reserve diversification has picked up steam. Oil prices, though lower today are still at extremely lofty levels and in the words of President Bush, “it will be a tough summer for US consumers.” Consumer confidence, due for release tomorrow, is expected to be heavily impacted by the recent climb in oil. Most of the US data due for release this week is expected to be weaker except for first quarter GDP. Therefore, the tone has been set by the G7 meeting and if history is a reliable indicator, then we could expect a bit of consolidation and then another fresh wave of selling.

Euro

The Euro is benefiting from broad dollar bearishness as well as more talk of reserve diversification. The latest central bank to talk of their demand for Euros was the governor of Qatar’s central bank, who said that they have recently been buying Euros for reserve purposes and although their current reserve makeup is confidential, up to 40 percent of its currency reserves could be moved to Euros. The UAE is also considering shifting another 10 percent of their reserves to Euros next month, which follow’s Sweden’s announcement on Friday that they have increased the Euro share of their reserves from 37 percent to 50 percent. On top of that, after talking down the dollar’s status as the absolute reserve currency on Friday, Russia announced today that they would allow their $61 billion oil fund to invest in bonds issued not only by the US and Britain, but also by Eurozone countries. With the breakdown of the EU Constitution well behind us, the market has feels that reserve diversification is a theme that is here to stay. Meanwhile French figures came in much stronger than expected today with business confidence rising from 106 to 108. German industrial production for the month of February was up 1.0 percent with an upward revision from -0.1 percent to up 0.4 percent the previous month. This is in line with continued improvement in the Eurozone economy and the need for more rate hikes by the ECB. It remains questionable though how hawkish the central bank will be. ECB President Trichet is speaking at 5pm EST, so it will be interesting to see if he talks down the Euro once again following a 300 pip rise over the past week.

British Pound

The British pound is soaring today thanks not only to dollar bearishness, but also firmer UK data. Retail sales increased a more than expected 0.7 percent last month even though there was a milder downward revision the previous month. This is quite encouraging in the context of generally mixed economic data. Consumer spending has remained relatively stable, which should help to offset some of the bearish sentiment brought on by the weak inflation growth figures reported last week. Nonetheless it doesn’t change the landscape much for the Bank of England. The central bank is still expected to leave interest rates unchanged. Mortgage lending and public finances both increased more than expected indicating that for the time being, the UK economy is holding on.

Japanese Yen

The Japanese Yen was undoubtedly the day’s biggest mover. After having range traded for 2.5 months, the currency has finally broken out and is dictating overall market activity. As the proxy for Asia, the yen is most sensitive to any developments in China and at the moment, the big question is how China will respond. In the worst case scenario that China is also branded a currency manipulator as we mentioned in the dollar section, will that be enough to force them to change their currency regime? China has proven to not be one to succumb to international pressure and each move that they have made in the past has been very politically astute. Just take the Chinese President’s visit to the US. Even though there was widespread speculation that the Chinese President could make a major foreign exchange related announcement – he didn’t. Yet ahead of the US Treasury’s report, China may very well make a minor but symbolically important shift that if branded as a currency manipulator, they could use as rebuttal. A major shift however will be unlikely since China has already downplayed the G7’s criticism. In addition, as indicated by Stephen Roach of Morgan Stanley, China does not want to be the scapegoat for the US’ self created problem. He argues that “America’s unprecedented savings deficiency” is what got the current account balances to where it is now. More interestingly though, he adds that back in the 1980s, when the US had its first major current account deficit, it screamed unfair value and pressured Japan, the country that it had the biggest gap with back then the same way it is pressuring China now to let the yen rise so that the gap would be closed. Japan agreed and let USD/JPY slide but sadly the strong yen was what fueled the major asset bubble that eventually led to the Asian Financial crisis. Roach says that China is far weaker economically now than Japan was then and in such a sensitive time, they probably have no interest in making the same mistakes that Japan did. These are fascinating comments by Roach that are well worth noting.

 

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