FYI | Oct 17 2006
By Chris Shaw
When signs first emerged a few months ago of a downturn in the US housing industry the US currency weakened, as it reflected increased fears the world’s largest economy was on the verge of sliding into a recession that would force the Federal Reserve to begin cutting interest rates to stimulate growth.
In the space of several weeks this view has changed though, with SVB Financial Group pointing out the market has again returned to its soft landing scenario for the US economy as the latest economic data shows the slowdown in the housing sector has not flowed through into other sectors of the economy.
The group also notes the latest Federal Reserve comments have been hawkish rather than dovish, as it has indicated inflation will remain the focus rather than the rate of economic growth. As a result, this has seen those who a few weeks ago were factoring in rate cuts having to adjust their expectations to account for the potential for rates to move even higher.
As Credit Suisse notes, this would enhance what are already historically large interest rate differentials between the US and Europe, Japan and Switzerland. As an example the broker notes these differentials are around 4% between the US and Switzerland, with the last time such a wide differential was in place producing a prolonged and significant period of US dollar strength.
While the broker expects this differential to narrow somewhat going forward it doesn’t see the gap closing completely, so conditions continue to favour the greenback.
At the same time there have been other factors supporting the US currency, with the group pointing out weaker oil prices in recent weeks are a plus for the US dollar as it acts as a tax cut for consumers, helping maintain domestic consumption at strong levels.
It also works against the euro, as on SVB Group’s estimates European nations export three times as much to oil producing nations as does the US, so lower oil revenues will have a greater impact on the euro than on the dollar.
This adjustment has been reflected by the gains in the currency, as the group notes when fears about the US economy and its structural imbalances were highest in August there were record short positions in the greenback, with most traders expecting the euro to strengthen.
Now these have been unwound and the US dollar has pushed through key resistance levels against not only the euro, but also the yen, pound and Swiss franc. SVB expects this trend to continue over the next few months, with further gains likely against the euro if the US dollar can break through the 1.2456 level.
While anticipating further strength SVB is not calling a bull market for the greenback, as it points out there remain structural issues for the economy that may again emerge as a focus of market attention, while the overall slowdown in growth is not likely to drive the currency significantly higher. Credit Suisse agrees, noting the US current account deficit remains an issue as it could disrupt the inflow of funds currently supporting the US dollar.
As a result, SVB’s forecast is for the dollar to trade in a range of 1.20-1.30 against the euro in coming months, there being little likelihood in the group’s view the euro can move above the 1.30 level given it expects the European Central Bank (ECB) will complete its rate hike cycle this year.
On Credit Suisse’s model the euro is expensive so it also favours being long the US dollar, while it suggests the interest rate differential will support the currency against the Swiss franc and capital outflows will support it against the yen.