Friday, May 19, 2006

Dollar - appreciating or depreciating?


The markets are confusing many, myself included. This is a time when even seemingly positive information is working against the respective home currency for "other" reasons. Let me explain.

When the Fed signalled that its monetary tightening might have come to an end at 5%, the expectation was that, say, sterling would appreciate against the dollar, as attention - finally - turned to fundamentals like the current account deficit and the inflationary impact of the insatiable appetite of the US consumer. But, even though sterling has appreciated against dollar, the impact of cheap imports has been disinflationary in the US, which has allowed investors to still see the dollar as a worthwhile vehicle for carry trades, creating some dollar support.

There was a recent upside surprise in US inflation data, which now has markets speculating that the FOMC may raise interest rates to keep in inflation under control. This has generated two opposite views:
1. Some will now go long on the dollar, expecting the inflation-controlling moves to be supportive from a currency perspective.
2. Others are selling dollar because they are concerned that the US may be close to the tightening tipping point, from which further interest rate rises will cause a retrenchment in consumer spending and a slowdown in the rate of economic growth.

So, the question is do you buy dollar or sell dollar? Apparently dollar traders have been selling Euro and buying dollar (which supports a dollar appreciation), and Euro traders have been doing the opposite, selling dollars and buying Euros (resulting in Euro stability).

The consensus seems to be that the dollar should depreciate but nobody wants it to do so relative to their currency, and especially not the Asian economies. Therefore, there may be some intervention that is preventing the dollar from breaching the $2/£ mark.
In the UK, the housing market seems to be continually improving, retail sales volumes have also been improving (year-on-year); explained by short-term household liquidity (with price discounting in consideration), and surveys suggest a positive picture for the economy, which, in totality, makes a neutral-hawkish MPC look likely to turn more hawkish than neutral, a scenario that would favour sterling.

Which way are we going?
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Even with a more hawkish than neutral MPC, raising UK interest rates may not happen for the near-term. Why? Because, the sterling exchange rate index (ERI) has risen quite a bit, helping to keep the rate of UK inflation lower than it could be (because of cheap goods for UK consumers, relative to our exports), which is comparable to raising interest rates. So the ERI has done/is doing the job for the MPC, creating a disinflationary environment.
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I don't know how anyone can make a decisive strategic decision regarding dollar-sterling at the moment. Does anyone hold a different view?

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