For the US Dollar, New Climate, Same Weakness

With the Fed taking at least a respite from raising short-term rates, the dollar will also be more vulnerable on yield grounds as the markets look forward, even though the nominal level of rates should still provide important short-term dollar protection.

The risk of dollar selling will increase sharply if there is evidence of more serious US economic deterioration, which would create pressure for interest rates to be cut again by early next year. The European Central Bank (ECB) and Bank of Japan are likely to increase interest rates again, although economic doubts are liable to increase in the Euro-zone toward the end of 2006, restricting euro gains.

Given the high current account deficit, the US dollar will also remain vulnerable on structural grounds. There is also liable to be pressure on the dollar as central banks diversify away from the US dollar as a reserve currency.

WEAK COMBINATION
This combination of factors will limit the scope for US currency gains. The net risks suggest a weaker dollar trend, although losses against the euro should be measured.

After sharp declines during April the US dollar found support close to the 1.30 level against the euro, and there was a corrective recovery with the US currency strengthening back to highs just beyond 1.25 in late June. From mid-July, increased market speculation about a pause in US interest rates undermined the dollar, with losses back to 1.29.

US economic data continues to be mixed, and there have been important variations across sectors. The evidence overall, however, has suggested a significant moderation in US growth.

The industrial sector has remained firm, with regional and national surveys suggesting further moderate growth over the next few months. Consumer confidence and credit data were robust for July, but the rate of retail spending growth has slowed as higher energy costs have curbed disposable income. Third-quarter gross domestic product (GDP) growth slowed to an annual rate of 1.6%, with business and consumer spending growth slowing.

The housing sector will continue to be an important focus following strong growth over the past few years. Rapid expansion in the sector was important in supporting wider consumer spending as housing values increased and there were strong gains for construction employment.

New home sales fell 11.9% in the year ended in June 2006 while housing starts and permits also slowed sharply, with permits dropping to a seven-year low in July. Confidence in the sector has deteriorated, and there will be further concerns a slowdown in the housing sector will undermine wider consumer spending levels and act as an important drag on wider economic growth. There is likely to be market speculation over a recession during the first half of 2007.

INFLATION EDGES UP
The main inflation indicators have gradually increased over the past few months. Core consumer prices rose 0.3% in June for the third successive month, and the core annual rate rose to a four-year high of 2.6%. There is evidence that rising energy costs are being passed through to the US consumer, although energy prices have moderated since Labor Day. Housing inflation rates are also being pushed higher by the influence of rising rents.

There has been a gradual acceleration of wage inflation over the past few months due in part to weaker productivity growth, and hourly earnings rose 0.4% in July to give an annual increase of 3.8%. Inflation concerns will continue in the short term, especially as oil prices rose to near-record levels in the first week of August. Consistently strong energy prices this year will increase the risk of prices continuing to be passed through to the consumer sector.

The inflation data reported in August offered some relief with core producer prices falling 0.3% for July while the underlying increase in consumer prices was held to 0.2% for the month, although the annual rate increased to 2.7%. Oil prices also dropped back, which will ease headline inflation rates, but there will still be concerns that underlying inflation will creep higher as price expectations rise.

Policy lags associated with monetary policy will be an important factor for the Fed to consider. The full impact of interest rate increases already in place will not be seen until late this year at the earliest, and tightening policy too far would risk a sharp economic slowdown next year that could trigger a recession. The Fed, however, will need to anchor inflation expectations, as the costs of reversing an underlying increase in inflation could be very high.

In its statement after its August 8th meeting, the Fed said that it expected inflationary pressure to moderate, although it emphasized it was anxious to maintain policy flexibility and that any future tightening would be dependent on forthcoming data. The most likely outcome would be that rates will not increase again, and 10-year bond yields would fall back to near 4.80%.

INVESTORS' NEW LANDSCAPE
The probable peak in US interest rates will tend to undermine near-term dollar support, especially with the market contemplating when US rates could be reduced again. The selling pressure will, however, be limited by the fact that US nominal rates will remain above euro and yen rates, which will discourage aggressive dollar selling. The Fed will also be prepared to push rates higher again if there is no sign of a deceleration in inflation. Fed credibility on inflation and the wider economic performance will be important issues over the next few months. A controlled slowdown for the economy and an easing in inflation would provide an important boost to Fed credibility.

Structural issues will remain important for the US currency, especially as the current account deficit is still running at levels above 6% of GDP. The US trade deficit continues to run well above $60 billion a month, although the underlying deficit has shown signs of stabilization over the past few months. However, a clear improvement will be needed to boost dollar sentiment, especially with high oil prices continuing to exert upward pressure on the deficit. There will be some relief that investment income flows have held reasonably firm.

There have been further reports of central banks selling dollar holdings to rebalance their holdings after a buildup of dollar reserves over the past few years. The overall evidence is mixed, especially as banks are cautious about divulging the composition of reserves, but there has been a reduction in official bond buying.

Any significant euro retreats are likely to be met with strong institutional buying interest, and these forces are likely to act as a strong barrier to significant dollar gains over the next few months.

The bank is also concerned about the rate of monetary creation. July M3 money supply growth was still at 8.5% compared with a longer-term target of 4.5%. Household lending also remains strong, particularly in the property sector. The ECB remains anxious to keep inflation expectations under control and, in this context, it will be looking to increase rates again before the end of 2006.

Euro-zone economic indicators had been showing steady improvement although some mid-summer numbers were slightly disappointing, especially from Germany. If the economy shows clear signs of a slowdown, the ECB will come under greater pressure to pause monetary tightening.

SLOW RISE IN JAPAN
The Bank of Japan increased interest rates to 0.25% from zero in July, the first tightening in nearly 10 years. From now on, Japanese interest rates are likely to increase only slowly with a further 0.25% rate increase realistic during the fourth quarter.

Nominal interest rates will remain low, but the overall tightening of liquidity will be important in global markets. The tighter liquidity conditions will make it more difficult for countries running current account deficits to attract capital inflows. In this context, the US dollar is likely to be more vulnerable over the next few months.

After a flurry of concern when the euro strengthened sharply during April–May, European officials have been generally calm over the exchange rate. In general, policymakers seem to be more concerned about the rate of currency appreciation rather than the outright level, but there will still be unease if the euro strengthens back above the 1.30 level against the US dollar.

Darrell Jobman is editor-in-chief of www.TradingEducation.com, a website providing free information and education to traders. He is an acknowledged authority on the financial markets and has been writing about them for more than 35 years.