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FX Briefing

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US government comes to the aid of the dollar

Fri, Jun 20 2008, 10:09 GMT
by BHF-Bank Economics Department

BHF-Bank

Highlights

• Bernanke sees downside risks to growth diminishing, and inflation risks increasing

• ECB dampens interest rate hike speculation; no series of rate hikes on the cards

Dollar on the road to recovery

Speculation about interest rate hikes in the eurozone, weak US labour market and trade data, and clear signs that the credit crisis is still far from over for US banks pushed EUR-USD over 1.58 at the end of last week and the beginning of this week. During the course of the week, however, this development was reversed again: the dollar firmed right across the board: EUR-USD fell to below 1.54, USD-JPY rose to over 108. The US dollar posted similar gains versus most European currencies and also against AUD and NZD.

On the US side, persistently hawkish comments from the Fed plus remarks made by US Treasury Secretary Hank Paulson helped to bolster the dollar. According to Fed Chairman Ben Bernanke, the danger of an economic slump has diminished over the last few weeks. He said that fiscal and monetary policy stimulus, a gradual ebbing of the drag from the housing market slump, still solid demand from abroad and further progress “in the repair of problems in financial markets”, should help the economy. At the same time, he warned of the potential danger of soaring commodity prices feeding through to consumer prices and wage costs, and of the upside risks to inflation expectations.

Recent comments by Treasury Secretary Hank Paulson confirm the impression that a monetary policy change is underway in the US: whereas in the past, the US government had mainly just paid lip service to the importance of a strong dollar, Mr Paulson has now pointed out that the longterm fundamentals of the US economy are strong compared with other industrialized countries. Market participants also pricked up their ears at Mr Paulson’s remark that he was not ruling out the possibility of intervening to support the dollar.

The Fed’s view was for the most part underpinned by US economic data. Retail sales rose by 1.0% month on month (ex autos by 1.2%) in May, which was much better than expected. Furthermore, the April figures were revised upwards to show quite a robust rise in the second quarter of over 1% quarter on quarter. Although the retail sales figures, which are in nominal terms, are likely to be much higher than the real rise in spending, private consumption could still have made a positive contribution to growth again in Q2. The development in May could also indicate that the tax rebates are actually being used for additional spending.

In contrast to the Fed, several ECB representatives attempted to quash rate rise expectations. They apparently felt that the markets, which had recently priced in two to three interest rate hikes, had got the wrong message: ECB president Jean- Claude Trichet, Executive Board member Jürgen Stark and Bank of France governor Christian Noyer all indicated that the ECB was certainly not considering a series of interest rate increases at the moment.

The markets, however, are taking the ECB utterances with a pinch of salt. This is partly because there is still a very real danger of inflation accel erating: oil is currently trading at around $137/b, just marginally below its peak and well above the average price in May. Furthermore, it looks as though May inflation in the eurozone, which was high as it was, will be revised upwards. According to the results in the individual countries, inflation could have risen to 3.7%. Moreover, developments in the US are having an impact here too: during the course of the week, the yield on 2-year T-notes jumped from 2.40 to almost 3.10%.

The euro’s interest rate advantage over the dollar, which had temporarily risen to more than 220 points last week, has now steadied at around 160 points – roughly the interest rate spread over the last three months. In our view, it is unlikely to narrow further at the moment, especially as we see the interest rate expectations in the US – an increase of 75 to 100 bp by the end of the year – as being fairly aggressive. Nor are we expecting the G8 meeting to give the dollar a fresh boost.

The downward movement of EUR-USD has now gained a certain momentum, however. The euro has breached key resistance levels and is currently at its lowest level in over five weeks. Furthermore, it looks as though Ireland could reject the EU Treaty, which would put additional pressure on the European currency. Against this backdrop, we consider it more likely that the dollar will continue to strengthen, not only in the short, but also in the medium term.

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Published on  Fri, Jun 20 2008, 10:13 GMT