Foreign Currency Report 04 December 06

ECB
Currency markets will open on edge this morning after last week's sharp decline in the dollar, with traders looking to new economic data and the tone from the European Central Bank for fresh reasons to trade on the dollar.

The latest bout of dollar weakness has occurred as currency markets have developed a growing belief that the US economy is in worse shape than the Federal Reserve claims. They have also been encouraged to buy the Euro by the lack of concern expressed so far by ECB officials about the rise of the single currency.

On a trade-weighted basis, the dollar has declined nearly 4 per cent since the middle of October, with more than half that fall being recorded since November 20.

The ECB will this week be watched closely for clues about future Euro zone interest rates.

Financial markets will scrutinise carefully the words of Jean-Claude Trichet, ECB president, for signals on the pace of increases in 2007 and any signs of concern on the currency.

Some analysts think Mr Trichet may seek to create more room for manoeuvre on the timing of future moves, increasing the risks for traders purchasing euros.

The most important release of economic data will be the US employment report on Friday. The US labour market has held up strongly despite declines in the housing market and in survey data, and has helped to underpin official's belief that the US economy is still set for a soft landing.

On Friday Don Kohn, the Fed vice-chairman, repeated the Fed view that while the inflation trend 'seemed to be shifting' and the Fed's base case was for a 'gradual decrease' in price pressures, 'the risks around that expectation are still tilted to the upside'.

Fed officials have long been puzzled by the market's confidence that the next move in rates will be down, that rates will be cut soon, and that this rate cut will be the first in a series.

Fed policymakers see this as a plausible scenario, but are more minded than the market to put weight on other possible scenarios.

Some traders are sticking to the view that the Fed sets rates and so should be listened to more closely. Marc Chandler, global head of currency strategy at Brown Brothers Harriman, said the currency markets were too fickle. 'In the battle for control of US monetary policy, we suggest betting on the Fed.'

But many investors are showing a growing desire to ignore Fed comments. Adrian Schmidt, senior forex strategist at Royal Bank of Scotland, said: 'Under normal circumstances, hawkish comments from the Fed would have helped the dollar . . .  Until financial markets start to pay more attention to the idea the Fed is unlikely to cut rates next year, the dollar is likely to remain under pressure.'

There is no indication that the most recent data have changed the Fed's basic sense that the US economy is heading for a broadly soft landing.

USD
On Friday the pound closed only two cents below the $2 level, which has provided a sure-fire signal for buying dollars and selling sterling for 25 years. The Euro, though not quite as strong as the pound, is less than 3 per cent away from the record high that it hit at the end of 2004, a peak that was followed immediately by a 20 per cent plunge and a corresponding gain for the dollar.

Most telling, newspaper headlines are screaming that the dollar is becoming worthless, while market leaders, central bankers and politicians seem to be in unanimous agreement that there is only one way for the US economy and currency to move from now on, and that that is down.

Financial papers have been publishing leaders or analyses almost daily to explain why the fall of the dollar is inevitable and why it should be welcomed, not resisted, provided that it does not get out of hand.
Such media excitement and especially magazine cover stories are usually reliable contrary indicators of a change in trend. Once the whole world believes that a currency will keep on falling, there is nobody left to sell it and, therefore, the trend is likely to reverse.

The big question today, not only for currency speculators but also for businessmen and politicians whose fortunes depend on the global economic outlook, is whether the dollar and the American economy have reached such a pivotal point. Rarely in living memory has an important currency, or any financial asset, been as friendless as the dollar is today.

So, on the tried-and-tested contrarian principle that the best time to buy is when everyone else is selling, the dollar and other US assets probably offer extraordinary bargains today. This is especially true because most of the supposedly fundamental reasons why the dollar is falling appear to be bogus.

For example, the idea that higher interest-rate movements offer stronger support to the Euro than the dollar is simply untrue, since the gap of two percentage points between US and European rates today is wider than it was in 2005, when the dollar was rising, and there is almost no chance of this gap disappearing or even narrowing substantially in the next two years.

Nor is it true that prospects for economic growth point to a lower dollar. Although growth in the United States is slowing, so is growth in Europe and Japan and there is more likelihood of a reacceleration in America by the second half of next year. In fact, the Euro zone and British economies are likely to suffer a severe slowdown if the Euro and the pound remain at anywhere near present levels against the dollar and the Asian currencies, which is why I believe that a big change of direction in the currency markets is probable very soon.

But what about global trade imbalances Surely, America's huge trade deficit explains why the dollar is so weak. This may seem to be a plausible argument for the weakness of the dollar, but can trade imbalances possibly explain the extraordinary strength of the Euro and the pound The answer is 'no'. If exchange rates were still driven by trade, as they were in the 1970s, then the only tradable currency going up against the dollar would be the yen, since Japan has by far the world's largest trade surplus and is the only leading economy whose surplus is steadily growing.

Yet the yen is the only significant currency that has not risen against the dollar this year. This is not the time to explain in detail why trade balances are almost irrelevant to currency levels in a world of globalisation and deregulated financial markets, but suffice it to say that there has been a certain inconsistency, to put it mildly, between the theory that currencies are driven by trade performance and the empirical experience of the past decade. After all, the dollar, which is supposed to be driven by the world's biggest trade deficit, has fallen by exactly the same amount this year as the yen, which is supposedly driven by the world's biggest surplus.
Now let us juxtapose the fundamental arguments, which are, if anything, rather favourable to the dollar, at least in comparison with sterling and the Euro, against the hugely lopsided balance of market opinion.

This is unanimously bearish about the dollar and wildly enthusiastic about the Euro and, to a lesser extent, the pound. This contrast suggests that the dollar is about to turn, perhaps in a very big way.
The irrational bias in market sentiment does not, however, tell us when the trend will turn or at what price. And until the trend does turn, investors who try to fight it risk losing their shirts. And how do we know when the trend has turned Some years ago Brian Marber, one of the City's best-known and most-respected currency analysts, devised a rule for assessing trend changes that has, on the whole, withstood the test of time. Marber's law states that when a currency reaches within 1 per cent of a previous important high, it enters a 'twilight zone' from which it could easily emerge in either direction and as soon as it does emerge, with a move of 2 per cent or more, that establishes the new trend.

Last week the dollar entered the twilight zone against sterling. If the pound now rises above $2.06, it will keep moving upwards. If it falls below $1.95, it has nowhere to go but down.

So what should the investor do Hedge your bets until it is clear whether the pound decisively breaks through the $2 barrier. If it does, it could well go a lot higher in the short term. But if the pound tests the $2 barrier and then falters, it will be time to take a flutter, if not mortgage your house.

GBP
Investors are buying sterling as they expect the Bank of England to raise interest rates in 2007, while a weaker US economy could see rate cuts there.

Higher interest rates help strengthen a currency by making investments in that denomination more attractive.

But there are signs that the strong pound is hurting UK exporters, whose goods become more expensive in the US.

In late trading, one pound sterling could buy $1.981.

The dollar also weakened against the yen and the Euro, slipping to a 20-month low against the Euro zone currency after figures showed a contraction in US manufacturing activity.

The latest monthly CIPS data on UK manufacturing activity showed a marked fall in factory orders in November, which some economists said was connected to the strong pound hitting exports.

"Against the background of an expanding Euro zone, that is slightly surprising," said Philip Shaw, an economist at Investec.

"This could be a warning of things to come if sterling remains as robust as it has been against the dollar and the Euro to a certain extent as well."

The disappointing CIPS data suggested that the Bank of England might not be so keen to raise UK interest rates in the near future and prompted some profit-taking from traders.

As well as making UK firms less competitive in US markets, a strong currency also devalues the value of dollar earnings made there.
Many of Britain's largest firms, including Astra Zeneca, Hanson, BP, BAE Systems and Unilever, rely on the US for much of their profits.
The dollar's relentless slide this year has seen it fall in value by nearly 15% against sterling.

For some, this is good news - particularly for UK shoppers planning to travel to New York or other big US cities to buy their Christmas presents.

On reaching $1.9748, the pound had hit its highest level against the dollar since Black Wednesday in September 1992, when it crashed out of the European Exchange Rate Mechanism (ERM) under John Major's Conservative government.