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Where Will The US Find Dollar Support?
By Darrell Jobman
Monetary trends in the first quarter of 2006 may
have the answer.
Monetary policy will remain very important for currency trends
during the next few months, even if the markets give greater
attention to the growing US trade deficit.
The exact timing of a peak in US interest rates is difficult to
forecast, but there is a strong possibility that rates will peak in
the first quarter of 2006. Thereafter, short-term US rates should
not change very much for the remainder of 2006.
The European Central Bank (ECB)
is likely to increase interest rates steadily during the year with a
rate around 3.0% realistic by the end of 2006. The Bank of Japan is
set to abandon its ultra-expansionary monetary policy during the
first half of 2006, potentially in April, although interest rates
will stay low.
Nominal yields will continue to favor the US dollar, but the gap
relative to the euro and yen is unlikely to widen significantly
further. In fact, spreads are likely to narrow from late in the
second quarter, and with markets looking forward, the US dollar will
find it more difficult to attract capital inflows. A benign series
of events is possible, with the dollar settling into a trading range
as interest rate differentials stabilize or narrow slowly. Of
course, there is also still the risk of sharper dollar falls if the
markets start to price in a quick US interest rate cut.
FIGURE 1: SHORT-TERM INTEREST RATES.
The Federal Reserve increased interest
rates at every meeting of the Federal Open Market Committee (FOMC)
during 2005. in the Eurozone there was only one interest rate
increase during this time period.
INTEREST RATE TREND CHANGES
Even if attention reverts to US structural issues, monetary policy
and interest rates will remain an important determinant of exchange
rates. Interest rate trends in the major economies, therefore, will
remain a crucial market focus throughout 2006. It is particularly
important to look at potential turning points in the monetary cycle,
especially as these can also signal important changes in economic
trends and currency direction.
The Federal Reserve continued to increase interest
rates in 2005 at every meeting of the Federal Open Market Committee
(FOMC).
For the first 11 months of the year, there were no changes in the
Eurozone or Japan (see Figure 1). As a result, the dollar secured
support from widening interest rate differentials as higher US
interest rates attracted funds into US securities and discouraged
dollar selling.
The effect of global interest rates was amplified by one of the
other important themes during 2005: the flow of funds into
commodities and high-yield assets. There was a clear temptation to
use low-yield currencies as funding vehicles for investment in
high-yield and commodity investments (Figure 2).
During 2004, US interest rates at 1.0% were a clear incentive to use
the dollar as a funding currency, but attention switched to the euro
and particularly the yen in 2005 as US short-term interest rates
continued to increase. The outlook will be much less predictable in
2006, as there will be important monetary debates in all three
economic zones as far as short-term interest rates are concerned.
US PERSPECTIVE
Although the Fed increased short-term interest rates to 4.25% in
December 2005 from lows of 1.0% in 2004, the latest data shows the
US economy still performing well with solid growth in most sectors.
Consumer confidence has recovered strongly from the third-quarter
hurricaneomic and energy-influenced slump, but there will still be
uncertainties over spending levels, especially with a very low
savings rate.
The housing sector will remain an important focus in the short term,
especially with persistent signs of a slowdown in the sector.
Existing-home sales have started to weaken, while houses for sale
are running at record levels. Overall, with interest rates higher,
there is likely to be a slowdown in the housing sector. This will
create caution within the Federal Reserve, as a slowdown will have a
significant impact on wider consumer spending trends.
Headline inflation figures started to moderate with a
0.1% decline for December 2005 consumer prices after a 0.6% November
decline. Core consumer prices have continued to expand gradually
with an annual rate of 2.2% for 2005. The core inflation figures in
the gross domestic product (GDP)
and personal spending reports have also pointed to moderate price
rises. The Fed will still be very cautious about inflation,
especially if crude oil prices reignite and sustain a move above $70
a barrel.
The Fed will need to be forward-looking on policy as
the rate increases already sanctioned will not have their main
impact until later in 2006. This is an important issue within the
Fed, illustrated by the December FOMC
minutes. There were some divisions within the Fed, with members
overall expecting that the number of interest rate increases now
required would not be large.
FIGURE 2: WHERE WILL US DOLLAR
FIND SUPPORT?
After rising in November to its highest level
since May 2004, the US Dollar Index has slumped and probably
won’t have an interest rate advantage to help support it in
2006.
During 2006, the Fed will have to be much more responsive to ongoing
economic trends and will certainly not be able to tighten in a
mechanical fashion. In this environment, communication from the Fed
to the markets will also be less straightforward.
New Fed Chairman Ben Bernanke will want to maintain policy
stability. He will also be reluctant to take a soft stance early in
his tenure, so the Fed may not be eager to stop interest rate
increases. Any perception that the Fed is taking a soft stance on
interest rates could undermine confidence in his inflation-fighting
credentials and destabilize dollar confidence.
However, the equation will be very different in March if the economy
is slowing significantly as the markets would be looking for
interest rates to peak. Ironically, Bernanke is liable to face one
of his toughest tests at the start of his tenure. The risks of a
slowdown will increase during 2006 as a whole, but background
inflation concerns will persist. Given the net economic risks, the
Fed is unlikely to tighten beyond the second quarter of 2006.
EUROPEAN VIEW
The ECB
sanctioned a 0.25% rate increase in December 2005 to 2.25%, the
first increase in five years, and rates were left unchanged in
January 2006.
The evidence suggests that the Eurozone economy is generally
stronger, led by strengthening industrial exports, although
conditions remain patchy with some doubts over consumer spending.
The German economy still has a crucial impact on the Eurozone
economy as a whole, and the evidence from Germany has been
particularly encouraging. There has been a strong improvement in
confidence with evidence of rising consumer spending and falling
unemployment. The German industrial sector is also stronger.
The ECB
will be concerned about inflationary pressure, although the headline
rate should continue to moderate in the short term as energy price
increases come out of the annual calculations. The bank’s principal
fear is likely to surround the rate of monetary creation, which is
running above long-term comfort levels and, with overall monetary
policy still expansionary, this will encourage the bank to remove
the degree of policy stimulus.
There is little need for an aggressive tightening
from the ECB,
and there will be the risk of divisions within the ECB,
given the differences in national performances. Nevertheless,
increases of 0.50-0.75% are realistic in 2006 as a whole, with rates
likely to be close to 3.0% by year-end. Comments from ECB
officials suggest that a March interest rate increase is realistic.
JAPAN’S STANCE
The Bank of Japan maintained its quantitative easing policy
throughout 2005 as the central bank continued to battle with
deflation.
There has been a gradual easing of deflation during the year, and
the latest inflation readings recorded an underlying 0.1% consumer
price increase in the year to November. There has also been evidence
of a sustainable recovery in the economy, while there has been an
increase in property prices and an improvement in bank lending.
The overall evidence suggests that the conditions are in place to
suspend the emergency quantitative policy. There is, however, little
likelihood of a substantial monetary tightening, especially with
persistent fears that any policy tightening will damage the economic
recovery. The Finance Ministry will also continue to exert pressure
on the Bank of Japan to maintain an expansionary policy.
NARROWER YIELD GAP
Although US interest rates will remain higher in nominal terms, the
yield gap between euros and yen is unlikely to increase
significantly. The most likely outcome is that the differentials
will narrow, especially during the second and third quarters of
2006.
The trends in longer-term interest rates will also remain important.
Short-term rates play a very important role in driving short-term
capital flows and carry trades, but longer-term interest rates tend
to be more important in the context of structural investment flows.
US yield curve developments have been very interesting over the past
year, and much has been made of the yield curve inversion recently
with two-year rates above the 10-year level. The peak in US 10-year
bonds came in June 2004 when rates were at 4.85% just before the Fed
started its tightening policies and moved short-term rates up. Since
then, 10-year yields have been generally lower, with the most recent
peak at just below 4.7% at the beginning of November 2005 before
declining to just below the 4.5% level.
Darrell Jobman, the editor in chief for
www.TradingEducation.com, is an acknowledged authority
on the financial markets and has been writing about them for more
than 35 years.
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