Daily Insight

Memories are short, no more so than in financial markets. This time last year economists and traders alike were predicting doom and gloom for the dollar, and were to some extent vindicated, with the dollar making a low of 1.95 vs sterling and 1.35 vs the Euro in early 2005. Since then however, the greenback has gained over 12% against sterling, and 14% versus the Euro, and previous talk of a dollar rout is no longer on the agenda. The major factors contributing to the dollar rally have been better than expected news on the US economy, inflationary pressures due to rising commodity prices, and rising interest rates, making the dollar a more attractive investment now that it pays a decent yield. With eleven consecutive rate hikes over the last two years, it is no surprise that the balance has swung back in favour of the US currency.

Much of the shine was wiped off the Euro earlier this year when the new EU constitution was rejected by the French and Dutch, leaving the single currency under pressure. Sterling was favoured for a while, gaining sharply, but then falling back after the July bombings in London. Subsequent weak economic data from the UK has not been helping, and with the Bank of England cutting interest rates by 0.25% over the summer, it is not surprising that the pound has been weaker against the dollar. There is a strong possibility of a further cut before the year end.

The Euro has had its own problems recently, with Euro-zone growth forecasts to be downgraded, and uncertainty hanging over the region’s largest economy following the German election debacle.

The US economy on the other hand has apparently been doing rather well of late, and the impact of the recent hurricanes is expected to be short term. Despite falling sharply in the wake of Katrina, the market for US currency has been buoyant ever since. The real driver behind the strength however, is the Fed’s aggressive stance toward interest rates. After eleven consecutive hikes, it seems the appetite for higher rates remains undiminished, with a 0.25% rise shortly after Katrina sending a clear signal to the market that rates will go higher still in due course. Another quarter percent hike is in the pipeline at the November meeting.

The big question for the dollar is whether the Fed’s “measured pace” of rate rises will lead to a cash crunch further down the line, as businesses find the cost of borrowing starts to impinge upon growth prospects, and the consumer begins to retrench. Christmas sales will be an important barometer of consumer sentiment toward higher borrowing costs in 2006. The latest data from the US suggests that consumer confidence and spending is starting to decline, which may limit the Fed’s scope for further tightening. The consumer accounts for two thirds of the US economy, so quite simply, they must keep spending if the economy is remain healthy.

The arguments for further rate rises stem from the inflationary pressures that have arisen over the past 24 months, in particular the persistently rising oil price. The PCE Price Index (The Federal Reserve’s favoured measure of inflation) came in higher than expected last week, as did the Chicago PMI, both of which are supportive for the dollar. However, if the higher prices being paid by companies cannot be passed onto the consumer, it leaves the Fed’ in a quandary over what to do next. If rates rise too far, or too fast, the consumer will at some point feel unable to continue spending, and demand/consumption will fall. Unfortunately, the high oil price will not be brought under control by the Fed’s attempts to curb inflation at home, since most of the rising demand for oil is coming from outside the US, notably from growing economies like China. With the inflationary demand coming from outside the US, there is little that can be done to help bring down the price unless supply can be increased.

The market is betting heavily on the Fed’s interest rate drive being successful in bringing inflation under control without damaging the consumer. Funds are pouring into the dollar from Asian investors seeking yield, as interest rates in Japan are still close to zero. The Yen has also been falling against the dollar in recent weeks as this trend accelerates. US government bonds now yield 1% more than German government bonds.

Many investors associate a rising dollar with a stabilising US economy and an improving investment climate. However, this is not necessarily the case. Inflation, and the fear of inflation is driving funds into gold, which is up 20% so far this year, or 33% if you discount the appreciation of the dollar. In other words, the dollar has been in demand recently, but gold is now the world’s favourite currency. This holds true against the notion that the Dollar’s rise against the Euro and Sterling is not a case of it being the best currency to hold, but perhaps the “least ugly” in the short term, with investors chasing short term yield rather than long term value. The furious dollar rally reflects the changing inflation and interest rate outlook, especially compared to the Euro and Sterling, both of which have had negative adjustments to their own rate outlooks over recent months. The UK is cutting rates, while the Eurozone is on hold at 2%, though data released in the last few days suggests that inflationary pressures may force the ECB to raise rates early next year.

In an article I wrote for www.appliederivatives.com last year I suggested that the rising gold price was in fact a function of the instability created by US foreign policy, and that prices were likely to hit $500 in short order. This now appears to be coming to fruition, and with the war in Iraq going nowhere fast, the situation is if anything deteriorating. Even a stronger dollar has failed to ease gold and oil prices, with both hitting fresh highs in the last few weeks, proving that the commodity bull is not simply a side effect of dollar weakness. The current 3.75% yield on the dollar may look appealing compared to the 1% of 2002-3, but as with all “high yield” currencies, there are risks involved in holding them. The dollar bought today is certainly not the same dollar as you were buying five years ago, and once the dust settles, it may well look like a risky play after all.

The long term technical outlook for the dollar remains negative. Against both the Euro and Sterling the dollar is still within a long term downtrend, and the last few days have seen it is testing the long term trend support at 1.7500 vs sterling (see chart below). The reaction here should enlighten us as to whether the recent dollar rally is sustainable, or whether it is simply a correction within the longer term trend.