Market Opinion
August 21 2005 Foreign Exchange
The Case For The Dollar As suggested last week, the fall through 1.2400 for EUR/USD triggered a dollar revival, taking the exchange rate back to the 1.2150 area. The next key support levels to watch are 1.2080-1.2100 and 1.2000. Short-term fluctuations aside though, we still favour the dollar medium term, on a technical and fundamental basis. Technically, the right shoulder of the long-term head and shoulders pattern on the monthly chart, to which we alluded some time ago, is forming rather well. The neckline comes in around the 1.1900-1.2000 area, a break of which could well lead to major dollar gains over the coming year or two. Fundamentally, the euro, and sterling too, are overvalued compared to the dollar. The US economy is in far greater shape than its European counterpart, with real GDP likely to grow by around 4.0% in 2005, versus a dismal 1.4% in euroland. While the region has shown signs of a recovery of late - vindicating for now the ECB’s decision to leave rates on hold – the Market Opinion jury is still out as to the sustainability of any such revival, especially in the absence of meaningful structural reform. Progress on employment laws and mobility of labour, for example, are long-term requirements to the promotion of a more business friendly economy. Of concern is that the reform-minded Angela Merkel may not secure a sufficient majority at the upcoming German elections to drive forward the reform programme, while we all know the outcome of the French referendum on the EU constitution, and the reasons given. Yet while the ECB may not be ready to reduce interest rates, it is by no means preparing to raise them. On the other hand, the data coming out of the US suggests that the Fed’s measured approach to tightening monetary policy is far from over. The greater than expected readings of both CPI and PPI highlight the inflationary risks from high oil prices. That said, while energy costs are starting to affect core inflation, the 2.1% y-o-y rise in ex-food and energy CPI in July is still only a slight acceleration from the June reading. Should oil prices stay bid, which we think likely, the pass through effect to core inflation will increase marginally though in time. Furthermore, while the US consumer continues to fire on all cylinders, the manufacturing sector is experiencing a healthy revival, highlighting across the board buoyancy in US economic activity. The Empire Manufacturing Index may have slipped in August to 23.0 from 23.9 the previous month, but it still registered considerably more than the 18.5 figure expected by the marketplace. With new orders jumping sharply to 33.75, from 19.15, the employment component rose to 10.17, its highest level since March. Interestingly, the six-month outlook index increased to 53.26, somewhat higher than the six-month average of 42.07. Ok, so the March 2006 eurodollar contract at 95.62 is implying a Fed funds rate of 4.25%, meaning another three hikes of 25bps from the current level of 3.50%. Even if the curve is out by a few basis points here or there, it is clear that US rates are still heading higher, and that the Fed will stay on top of inflation. This being so, the superior carry on offer will continue to benefit the dollar, at the expense of the euro, and as we said earlier, sterling too. One of the key advantages to holding sterling in recent times has been the attractive rate of interest received. However, as the differential over dollar rates erodes further, and the UK consumer remains on the back foot - due to increases in the cost of living from higher energy costs and increases in indirect taxation – so the pound risks further declines. We would not be surprised to see a minimum 10% depreciation versus the greenback on a medium-term horizon from current levels. As for USD/JPY, we are less bullish for three reasons. Firstly, the Japanese economy is showing signs of life, with the revival being underpinned by domestic demand, due to improvements in the labour market and corporate profitability. Secondly, chances are that PM Koizumi may well win the September 11 election, thereby ensuring a continuation of the reform agenda, with the possibility of postal privatisation down the line. Thirdly, foreign inflows into the Nikkei remain substantial, and could well increase going forward, as the bourse’s rally gathers momentum. The key risk to Asian stocks in general comes from higher oil prices. However, they have managed to overcome this obstacle recently, and we believe they will continue to do so over the medium-term. With this in mind, we see further upside for Asian FX versus the euro over the coming years. A final word on the dollar. What about the current account deficit, we hear you ask. A major structural issue, say us, and a clear downside risk. However, the latest TICS data shows that financing the shortfall, for now at least, is not a problem. In June, foreign investors increased their holdings of US assets by US$71.2bn, the most in four months. In addition, Japanese investors bought a net JPY154bn of foreign bonds in the week ended August 13, which is the largest amount since the week ending July 23. Going forward, we do not see the appetite for US assets among international investors diminishing. As we have maintained of late, the more US short rates rise, the more attractive the long end of the curve becomes. The US 10-year note is paying over 270 basis points more than JGBs and over 100 more than bunds. This is an attractive proposition to a fund industry ever in search of sensible levels of yield.
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