FYI | May 02 2006
By Chris Shaw (Tokyo)
When the US Federal Reserve indicated recently it was considering a pause in the process of ongoing increases in official interest rates (at least that’s how the market interpreted it) it was like a red rag to a bull, encouraging market participants to sell the US dollar in favour of other currencies.
Supporting such position taking was the state of the US economy and more specifically its twin deficits, which are increasingly becoming a point of focus in the sense any move to address the situation is likely to require the assistance of a weaker US dollar, as a devaluation in the greenback should at least improve the country’s current account deficit.
Adding fuel to the fire were the comments by the G7 towards Asia, where it encouraged nations in the region to address what it regarded as exchange rate misalignments by allowing their currencies to appreciate against the US dollar.
The overall impact has been a weakening in the US currency, a process most expect will continue over the course of the year, particularly as there remains pressure on China to do its bit to improve the US trade deficit by revaluing its currency higher. As Danske Bank points out, such a move would also push the Yen higher given its position as a proxy for Asian currencies generally.
The bank notes history shows pauses in the tightening cycle by the US Federal Reserve are traditionally not bearish for the US dollar, but it suggests this time may be different given the global focus on misaligned exchange rates and the current account deficit in the US.
Danske Bank does expect the process will be gradual though, a view Citigroup agrees with given there are seasonal factors that could result in bouts of profit taking and it is likely Asian central banks will intervene in foreign exchange markets to smooth out any volatility. Morgan Stanley’s currency guru Stephen Jen could not agree more.
Citigroup agrees further appreciations in Asian currencies are likely going forward, with the currencies to gain support from higher interest rates. This is already occurring, as China lifted official rates last week and Japan has announced an end to its easy money policy, setting the stage for future rate rises. Danske Bank adds there remains the likelihood of further interest rates increases in Europe, which if the Fed pauses would attract money to the euro at the expense of the US dollar.
Citigroup does point out there is a risk the readjustment occurs much more quickly than anyone expects, with the likely trigger being a move by Asian central banks to diversify their holdings of foreign reserves out of US dollar assets and into other asset classes. The broker suggests such a move could send the US dollar tumbling and lift interest rates not only in the US but globally.
Of course, markets never react totally according to expectations, with the US dollar reversing direction last night following stronger economic data from factors such as incomes, spending and construction. The economics team at ANZ Banking Group notes this has complicated what had appeared an easy currency play of shorting the US dollar, as the market is now uncertain as to whether the Federal Reserve will pause or continue to lift rates. Citigroup agrees the short-term outlook for the greenback has now become more clouded.
As ANZ points out though, this market noise and the possibility of US dollar strength in the short-term doesn’t change the fact significant imbalances in the global aconomy remain and they must be addressed. Therefore longer-term the outlook remains for the US dollar to weaken against other currencies.