Dollar's strength requires longer-term view

Economics: The US economy grew by 1 per cent in the third quarter of the year, dwarfing the 0.3 per cent gain recorded in the euro area, bringing the annual increase in American GDP to 4 per cent, or double the pace in Europe, writes Dan McLaughlin

Strong economies normally beget strong currencies yet, in recent weeks, the dollar has fallen to a new low against the euro, highlighting what may seem a perverse foreign exchange trend - the dollar's fall will probably give a further boost to US growth, whereas a stronger euro may crimp euro area exports and hence euro-zone GDP, so exacerbating the growth differential with the States.

Moreover, to many commentators there is no respite in sight, amid a chorus of voices calling for the euro/dollar rate to go much higher with forecasts of $1.40 or $1.50 not uncommon.

It has to be said that foreign exchange forecasting is one area in which the economic profession has a less than exemplary record, certainly compared to the accuracy of forecasts on variables such as GDP or inflation. Indeed, Mr Alan Greenspan, the chairman of the US Federal Reserve, recently remarked that one might as well toss a coin for guidance on the direction of short-term currency moves.

Medium-term forecasts of foreign exchange rates have a better record. In fairness, this is probably because more fundamental economic trends dominate in contrast to the short term where other factors such as market positioning and expectations play a big part. Yet media coverage of daily moves in markets tends to look for fundamental drivers, which can miss the point.

Certainly, the sheer scale of trading plans across all the markets - be it equities, bonds, commodities or foreign exchange - is now so large as to be a dominant theme.

The recent oil price rate illustrates the point. Brent rose from $40 a barrel to $52 in just three weeks in mid-September, prompting much discussion about a global oil shortage. In fact, the price rise was primarily driven by speculative buyers, which became clear in mid-October when the oil price fell back to the low $40s in jig time.

The foreign exchange market is prone to similar price action. Take 12 months ago, when the euro/dollar rate went from $1.15 to over $1.29 in a two-month period, giving rise to the now familiar dire warnings of a dollar collapse.

In the event, the euro gave up most of its gains over the following two months, and again one can explain most of the move through market positioning - the market had taken a huge speculative position against the dollar and, when the euro rally stalled, traders bought back the dollars they had sold, so driving the US currency higher.

A similar game is being played at the moment, with speculative selling of the dollar at record levels in recent weeks. Of course, such activity does not occur in a vacuum. Speculative activity takes place in anticipation of what one might call "real" money flows.

There is a widely held view that the Bush administration is not averse to a weaker dollar, as it might help to placate the US manufacturing lobby complaining about a flood of cheap imports, as well as providing a support to economic growth.

This is understandable but the fact that the euro has taken the strain makes less sense. Most commentators argue that it is the Asian currencies that need to rise against the dollar, given their competitive advantage in some areas of manufacturing, but some are unwilling to allow any movement at all (e.g. China, Malaysia) and others intervene in the market to allow only marginal changes (e.g. Japan).

The upshot is that the market takes the path of least resistance, selling dollars against those currencies where the policy makers are indifferent to their currency's appreciation.

Take the euro: the president of the ECB, Mr Jean-Claude Trichet, has called recent foreign exchange moves "brutal", but the market still has the impression that the dollar's fall is not entirely unwelcome in Frankfurt as it will dampen the impact of the recent rise in oil prices, which of course is priced in dollars.

One should also put the recent rise in the euro into perspective: the euro/dollar rate is currently 3 per cent above its level in the spring of 2004, and its average 2004 value against its main trading partners is also only 3 per cent above the 2003 average.

Consequently, I doubt the ECB will intervene unless the euro/dollar rate rises very rapidly towards $1.40, but two factors may push the euro lower anyway in the short term.

The first is positioning. As noted, above, the market is very short the dollar and at some stage will cover, prompting strong dollar buying.

In addition, US assets are becoming more attractive relative to those in Europe. A US 10-year government bond now yields 4.35 per cent against 3.75 per cent in Germany, a premium which has widened from virtually zero three months ago.

The upshot may be a euro/dollar rate trading below $1.30 in the next month or so, regardless of any long-term trend.

Dr Dan McLaughlin is chief economist at Bank of Ireland