Market Opinion Foreign Exchange

Market Opinion
Foreign Exchange

Well, other than a brief move above 1.2100, the short-term correction in EUR/USD that we were anticipating clearly failed to take place. 1.2120 is now key resistance for this exchange rate, a break of which would signal short-term euro strength. However, in the meantime, the dollar will continue to test the important 1.1900 area.

Readers will know that, despite last week’s view of a near-term euro bounce we have maintained the opinion of dollar strength for a number of months, having first become bullish above 1.2800. In fact, we almost titled this article A Matter Of Time, because at some point we feel that 1.1900 is going to give way, heralding a whole new lower trading range for EUR/USD. Indeed, we mentioned back in July the possibility of a medium-term move towards 1.0000, although on a technical basis 1.0800 is perhaps a more realistic target.

Fundamentally, two pieces of data interested us this week. Both, we believe, underpin our bullish dollar stance. Firstly, the US TICS data for August came in way ahead of expectations at US$91.3bn, the largest inflow since April 2004, with strong demand for corporate bonds. Ok, as of August, the US trade deficit totalled US$463bn, with the current account deficit hitting a massive US$524bn. Yet, TICS funding registered US$540bn, underlining what we have long been saying, that the financing of the current account shortfall is, for the foreseeable future, not a problem. Furthermore, the data revealed again that the private investor is the main purchaser of US assets, not foreign central banks, as is still widely perceived by various quarters of the market. In fact, private foreign investors purchased a total of USD83.5bn worth of US securities in August.

Interestingly, the TICS data throws up some discrepancy with regards to China. Some USD5.1bn worth of dollar assets were purchased by China, yet according to official data from the country itself, Chinese foreign exchange reserves increased by USD20.8bn in August. The excess money could simply be held on deposit, or a part of it may actually be used to buy dollar-denominated assets outside of the US. If so, then the TICS data may even be underestimating demand for dollar assets. We do not believe that this demand is going to dry up just yet, especially with US Treasury yields so attractive compared to other G7 bond markets.

The second interesting piece of data was the Philadelphia Fed Manufacturing Index, which rose to 17.3 in October, up from 2.2 in September, highlighting that manufacturing growth has recovered after Hurricane Katrina. The new orders, shipments, employment, and average workweek components all jumped, as did the prices paid index. The latter rose to 67.6, from 52.7, the highest reading since November 1980. In other words, despite hurricanes, oil prices and higher interest rates – which will likely see real GDP growth adjust lower in 2006 – the US economy is proving remarkably resilient. Moreover, the tightening cycle is far from over.
Against this backdrop, the market will continue to focus on growth and interest rate differentials. Of course, the current account deficit is a risk, which may yet return to haunt the greenback, but for now, at least, dollar-denominated assets are in demand.

With this in mind, we are still running with a stronger dollar against the yen, and against sterling. Interestingly, our belief in a mild dollar correction last week did actually happen to a very small degree against the GBP. Yet, as we have been saying for a while, once the interest rate differentials narrow further, what’s the point of holding sterling?

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