Dollar faces decline once again

Investor/An insider's guide to the market: At the beginning of last year there was a strong consensus that the US dollar would…

Investor/An insider's guide to the market: At the beginning of last year there was a strong consensus that the US dollar would continue to weaken during 2005. Not for the first time a consensus view on currency rates was completely confounded by subsequent events.

Instead of continuing to fall, the US currency appreciated strongly throughout the year. From its opening level of around $1.36 to €1, it finished the year at a much stronger dollar/euro rate of $1.19. In Investor's view the two key factors that wrongfooted the strong dollar consensus were, firstly, interest rate differentials, and secondly, the repatriation of funds by US companies.

Turning to interest rate differentials, the US Federal Reserve increased US short-term interest rates in a sustained and methodical fashion throughout 2005. Each increase in interest rates was by a modest 0.25 per cent, but the cumulative impact was a rise of two percentage points in the Fed funds rate to its current level of 4.25 per cent.

This opened up a relatively large gap in favour of the dollar as between dollar interest rates and euro interest rates, and between dollar and yen interest rates. This positive interest rate differential induced a much-increased demand for dollar deposits. It also led to an acceleration in the unwinding of the so-called "carry trade".

READ MORE

When dollar interest rates were as low as 1 per cent, many investors and speculators borrowed dollars and reinvested the proceeds in currencies with higher interest rates. However, as dollar interest rates continued to rise during 2005 traders scrambled to close these positions, which had the effect of increasing the demand for dollars.

The second factor to bolster demand for dollars in 2005 was a Bush administration tax incentive to US corporations to repatriate funds held abroad. This was a once-off incentive that could only be availed of in 2005, and it had the desired effect as US multinationals brought billions of dollars back home thus boosting the demand for the currency.

Market opinion towards the US currency remained upbeat throughout most of December. However, over the turn of the year there was a perceptible diminution in dollar-positive sentiment. As a result the dollar value to the euro quickly went above $1.20. The catalyst for this about-turn in the dollar's fortunes were statements emanating from the Federal Reserve to the effect that the period of US monetary tightening may be coming to a close. Market analysts expect the Fed to raise US rates by possibly another 0.5 per cent so that the peak in the current cycle is not now expected to go above 4.75 per cent.

At the same time the European Central Bank raised its policy rate by 0.25 per cent on December 1st and most analysts expect two more quarter-point rises in 2006 to bring the ECB rate to 2.75 per cent. Although the interest rate differential will still favour the dollar in 2006, the market seems to be focusing on the fact that the differential will not get any larger.

Consequently, the thorny issue of the persistence of the very large US trade deficit has moved back to centre-stage. The US trade deficit in October 2005 rose to $68.9 billion (€57.1 billion) and the running 12-month total is now in excess of $700 billion.

According to survey group Consensus Economics, the trade deficit could reach $832 billion in 2006. With interest rate differentials not expected to widen any further, the fear is that foreign capital inflows could slow as the year progresses and may not be sufficiently large to fund the deficit. This would create downward pressure on the dollar until it fell to a level considered to be attractive by foreign investors.

Many economists argue that the magnitude of an eventual decline in the dollar's value could be very large, with some suggesting a rate of dollars to the euro in excess of $1.50. While there are very few market forecasters expecting such a precipitous decline this year, there are many who believe that the long-term trend in the dollar remains downwards because of the persistence of the large trade deficit. For this group, 2005 will prove to have been a temporary respite in a necessary adjustment towards a lower dollar.

Investor's view is that the dollar will indeed decline in 2006 but expects the magnitude of this decline to be quite modest. Interest rate movements will again be the key to developments and if euro interest rates only rise by another 0.5 per cent to 2.75 per cent, then interest rate differentials will continue to limit the dollar's downside.

If, however, euro interest rates rise by more than currently expected in 2006, then the decline in the value of the dollar could be quite substantial.