Euro-zone loses out as weak dollar boosts US

INVESTOR An insider's guide to the market: Currency markets continue to grab the headlines with the euro reaching fresh all-time highs against the dollar on a regular basis in recent weeks.

Many active traders in the currency markets now expect the dollar to benefit from a short-term technical bounce given the sheer scale of its recent fall. However, the vast majority of economists expect the downward medium-term trend in the dollar exchange rate to continue for the foreseeable future.

Comments from some central bankers concerning a possible rebalancing of official foreign exchange reserves out of dollars has added a further twist to bearish dollar sentiment. In particular, Asian central banks have consistently purchased large amounts of dollar denominated assets. If these purchases stop or are even partially reversed, it could lead to further sharp declines in the US currency.

This would be particularly bad news for the euro zone where the strong euro is clearly having a negative impact on economic activity.

The evidence from a wide array of economic data and sentiment indicators now suggests that the pace of growth in the euro zone has slowed appreciably. Euro-zone business and economic indicators for November were weaker in stark contrast to the equivalent US indicators.

US releases for November portray a picture of improvement in business and consumer sentiment. Furthermore, the US GDP estimate for quarter three was revised up to an annual rate of 3.9 per cent from the initial estimate of 3.7 per cent. Personal consumption during the third quarter is now estimated to have grown at a rate of 5.1 per cent compared with the previous estimate of 4.6 per cent.

However, some data releases have been weaker than expected. For example, the key employment report for November fell short of expectations in terms of growth in non-farm payrolls of 112,000 net new jobs against market expectations of a figure closer to 200,000.

Nevertheless, the combined impact of recent information concerning the US economy supports the view that the economy's "soft patch" has now passed.

Developments in the oil market have played a significant role in this shift up in economic gear. Up-to-date figures for US oil inventories showed significant gains in stocks of all grades of crude and refined product, including heating oil. This information acted as a spur to a further decline in the price of oil.

With the price per barrel now trading around $42 it now seems that the move above $50 was a short-term spike. Many analysts now predict the oil price may soon settle into a $32-$38 per barrel range.

A lower oil price and a weaker currency are a combination that should ensure that the US economy goes into 2005 in buoyant form. For Europe, any stimulus from the lower oil price will be more than offset by the contractionary impact of the very strong euro.

This is particularly the case for the large European economies of Germany, France and Italy that are heavily reliant on export markets. In contrast, the faster growing peripheral economies such as Spain, Portugal and Ireland continue to grow at a healthy pace.

Financial markets have maintained a remarkable equilibrium throughout recent months. The big surprise has been the strength of bond markets.

The decline in long-term bond yields in the euro zone is not too surprising given the region's sluggish pace of economic growth. Of real surprise has been the decline in US bond yields in the face of a depreciating currency and rising short-term interest rates. Irish 10-year bond yields are now at 3.6 per cent compared with the 4.3 per cent available from 10-year US Treasuries.

This environment of very low bond yields has provided a positive backdrop to equity markets. During November the S&P 500 rose by 3.8 per cent and the FTSE Eurofirst 300 rose by 1.6 per cent. Once again the Irish market out-performed with a rise of 4.4 per cent over the month.

This firmness in share prices has been sustained into the early days of December. In the US market, low bond yields combined with an apparent resumption in growth have pushed up share prices. European equities have, in turn, benefited from the positive US sentiment with lower euro bond yields acting as a further positive influence.

Worries about growth have been pushed into the background and as long as bond yields stay low investors are likely to continue to commit new funds to equities, thus ensuring a strong finish to the year.