Market Opinion-Foreign Exchange
Dollar Resilience
Resilience is a word we have used several times over the past two weeks when talking about the US economic outlook. Last week’s statement from the Congressional Budget Office (CBO) suggests that while the odds are in favour of a pause in the US tightening cycle, the trend in interest rates is still upwards in direction.
Indeed, the CBO, in a document detailing the potential economic impact of Hurricane Katrina, argues that US real GDP growth is likely to fall by between 0.5-1.0% in H205, but would bounce in H106 by the same magnitude due to the boost from the extensive re-building effort. In light of this projected short-lived effect to economic activity, and the inflationary impact from the supply shock to gasoline prices, Federal Reserve officials remain in hawkish mode. Chicago Fed President Moskow has announced that even without an increase in inflationary expectations, appropriate monetary policy will be required to keep inflation well contained. That said, there will be growing pressure on Mr Greenspan to take his foot temporarily off the brakes, and in this respect communication of policy to the market will be highly important, so as not to promote excess volatility.
Of course, the risk is for a prolonged economic downturn, as the consumer curtails spending habits due to the more expensive cost of living induced by higher energy prices. This would have negative consequences for the rest of the world, and especially countries that export heavily to the US. Mexico and China spring to mind, with any slowdown in the latter having a knock-on effect for the rest of the Asia region. This is a worst case scenario, though, and, as you know, not one to which we adhere.
In fact, the US consumer may yet prove even more resilient than previously thought. Wal-Mart has stated that sales in the week immediately after Katrina were within the 2.0-4.0% forecast range for this month. In addition, the weekly Redbook retail sales data for the week to September 3 was not as bad as some had expected, with growth down to 3.0%, from 3.4% y-o-y. Even so, as mentioned above, the rise in gasoline prices will take their toll. With this in mind the fall in the front month gasoline future to around US$2.00, from a record high of US$2.92 the previous week, together with the backwardation of the strip, should mean that gasoline prices at the pump start to ease. That said, for the January future to be lower than it was before Katrina seems a little optimistic, meaning that prices could well bounce again, depending very much on the timeframe for the restoration of refining capacity.
Against this backdrop, yield differential will continue to offer underlying support for the dollar against the euro, especially as we see little chance of the ECB upping rates anytime soon. There are major downside risks for the dollar, though, such as a deterioration in the trade deficit, due to greater energy imports to offset production losses at home, and an increase in the budget deficit on the back of reconstruction costs following Katrina. These factors may well keep the three-month uptrend in EUR/USD in place, with a push towards 1.2800 possible over coming months as the US economy dips. That said, we still see no major problems on the horizon with regards to financing the current account deficit, with foreign investor appetite for US assets still strong. As a result, interest rate and growth differentials will provide medium-term dollar support. Immediate short-term, last week’s drop through 1.2460 for EUR/USD could take the exchange rate lower. A move through 1.2400 would presage a decline towards key support levels around 1.2270 and 1.2220, which we would expect to hold at this stage.
Visit Market Opinion [+]
|
