Prospects of dollar rally early in 2005 quite high

Investor: An insider's guide to the market: The key issues facing investors at the beginning of 2005 are remarkably similar to those at this time last year.

In early 2004 there was an almost universal consensus that the US dollar would weaken by a considerable margin. Following the sharp weakening of the dollar in the final months of last year there is again an overwhelming consensus that further dollar weakness is in prospect.

The prime reason cited is the persistence of the enormous US trade deficit. Also, the consensus view did prove to be correct in 2004 as the dollar depreciated against all freely floating currencies.

However, the annual movement in the exchange rate hides the fact that the bearish dollar consensus was seriously challenged in the first half of 2004. From early January to the end of April 2004, the greenback climbed by 9 per cent against the euro to the surprise of most market participants.

In particular, many hedge funds got badly burned during this period as their "short dollar" strategies yielded punishing losses. The losses sustained by many hedge funds during this period go a long way toward explaining why 2004 was a poor year for returns in the hedge fund industry.

Now, at the beginning of 2005, the prospects for a rerun of the early 2004 rally are quite high. In the first week of the New Year, the dollar rallied smartly and the dollar/euro rate has recently traded at 1.31.

Minutes released by the Federal Reserve last week stating that the central bank would continue to raise US short-term interest rates in 2005 acted as the immediate catalyst for the rally. The Fed funds rate now stands at 2.25 per cent and, barring a sudden collapse in economic prospects, the Fed will continue with its policy of regular quarter-point hikes throughout this year.

In contrast, the European Central Bank (ECB) made no change at all to its repo rate of 2 per cent. This rate has remained unchanged since June 2003.

At the beginning of 2004, the consensus view was that the ECB would begin to raise rates at some point during the year. As the months went by it became increasingly apparent that any interest rate rise would jeopardise the growth prospects of a very sluggish euro-zone economy.

At the start of 2005, a rate rise by the ECB still seems a distant prospect given the continued slow pace of economic growth in the euro zone. Therefore, as the year progresses, a significant positive gap will open up between dollar and euro short-term interest rates. This will lend some support to the US dollar and could well be sufficient to sustain a rally similar to the early 2004 rally.

However, the persistence of the large US trade deficit will probably again ensure that the trend of long-term dollar weakness will win out in 2005.

In the past, European equity markets have generally performed well during phases of dollar strength.

The early 2004 dollar rally was accompanied by a rise of 5.3 per cent in the FTSE E300 index compared with a gain of 1.7 per cent in the Standard & Poor's 500 (S&P500).

In 2003 there was another phase of dollar strength, which occurred from late May to early September. During that period, the dollar appreciated by 9 per cent and the FTSE E300 rose by 15.2 per cent compared with a 7.9 per cent gain in the S&P500.

Improved competitiveness and gains on the translation of dollar profits are the obvious factors that would explain this relative outperformance.

The ISEQ Overall index also outperformed the S&P500 on both of these strong dollar occasions. In the 2003 period, the ISEQ rose by 9 per cent and in the 2004 period the gain was 8 per cent.

However, these margins of outperformance are very small and, for 2004 as a whole, the ISEQ handsomely outperformed the S&P500 index.

It does seem that any currency-induced impact on share prices is short-lived and that other factors such as profits and interest rates are more important.

Probably the biggest single investment surprise in 2004 was the bond bear market that didn't happen. This time last year analysts were virtually unanimous in forecasting a rise in yields on long-term government bonds. In the event, yields declined across the board, seriously wrong-footing many active bond investors.

The question now is whether the bond bear market has just been postponed to 2005. The answer is probably not, as low rates of inflation across the globe offer no threat to bond yields. Also, economic growth is expected to be strong in 2005, although still slower than that experienced in 2004, so that excessive growth is not likely to create problems for bond markets.

As always, investors will have to wait and see how events unfold but most investors would be well pleased if returns in 2005 matched those achieved in 2004.