behavioural shift in fx market points towards greater focus on structural factors
The dollar has fallen sharply over the last month. Momentum suggests, at least in the short term, the dollar could approach the 2004 lows against the euro, sterling and Swiss franc.
The current weakness of the dollar appears to reflect two broad themes. The first is the perception in the markets that the US monetary tightening cycle is nearing an end while the European and Japanese monetary cycles have much further to go. Expected interest rate differentials have therefore narrowed, removing dollar support.
The second factor is a behavioural shift in the FX market, away from participants seeing interest rate differentials and 'carry' as the prime driver of currency movements, towards a focus on more structural factors.
The G7's call for Asia to introduce greater exchange rate flexibility has been seen by market participants, rightly or wrongly, as a call for a general decline in the dollar as part of the attempt to reduce global imbalances - namely the US current account deficit and its counterpart in the Asian trade surplus.
In any case, it is worth noting the dollar has already lost around 20% of its value against other currencies since 2002, which has not resulted in any material modification of global imbalances.
If US interest rates increase to 5.5%, our predicted forecast, it would maintain a significant differential in favour of the dollar relative to other major currencies.
We maintain our view of further Fed tightening, with the current strength of the US economy making it likely the Federal Open Market Committee's central projections for real gross domestic product (GDP) growth and inflation for 2006 are exceeded. Over coming months the interest rate differential against other currencies should therefore play a less dominant role than in 2005.
In Europe we maintain our interest forecast of 3.5%, with this peak likely to be reached early next year. However, recent data has been a little disappointing, with quarter one German GDP coming in below expectations. Moreover, if the euro is to strengthen further, this will dampen the growth and inflation outlook, given the so far largely export-led recovery.
In Japan the recovery is arguably more robust than in Euroland; markets appear to have brought forward their expectations about the Bank of Japan (BoJ) ending its zero interest rate policy. There is a real possibility of a rate increase for the first time in August.
On interest rates alone we would argue expected narrowing in the differentials should already be priced in and the recent dollar movements more than reflects this. However, many believe the Fed will pause at 5% and any signs of weakness in the economic data will reinforce this view.
The dollar correction needed to significantly reduce the US trade deficit would be so large there would be negative effects on global growth and inflation. However, the G7 and the US treasury clearly see a long-term need for greater exchange rate flexibility in Asia and an appreciation of Asian currencies.
But because of the lack of flexibility and liquidity in many Asian currencies, the bulk of the adjustment will, as usual, be taken by the dollar against the European currencies and, to a lesser extent, the yen.
The G7 always calls for orderly adjustments in currencies, however, such a wish is not always granted as market participants sense a shift in the ambitions of policy markets. Under current conditions, it is impossible to forecast how far the move in the dollar will go.
Sterling looks very expensive at current levels, particularly against the dollar. Moreover, the UK economy has just found its feet again after more than a year of sub-trend growth. There are a number of dollar earning companies in the FTSE 100 and analysts have started to revise down some earnings numbers.
On the basis that the current drivers of exchange rates, which includes a shift in forward interest rate expectations and a renewed focus on balances of the major currencies, the yen should be the strongest. The BoJ has yet to start raising rates but will do so this year, with predictions of some meaningful increases over the next couple of years.
By encouraging a dollar bear market, the G7 has unleashed some potential negative economic and market trends. It would not be the first time volatility has started in the FX market and then spread to other assets. At a time when bond markets are worried about inflation and rising interest rates, a dollar crisis could push some yields much higher. Equity markets will likely suffer from increased risk aversion and changes to the relative growth outlook.
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