Apr 2004 Financial News

U.S. rate hike prospects may carry risk for dollar

Apr 22, 2004

CHICAGO, April 22 (Reuters) - Traders agree that prospects for higher, yield-boosting U.S. interest rates are bullish for the dollar, but analysts warn that any unexpectedly steep rate increases could threaten stocks, bonds and the U.S. currency.

Markets are betting that official U.S. interest rates, now at a 1958 low of 1 percent, will rise by the end of August.

The prospect of rising rates is supporting the U.S. currency by making dollar deposits more attractive to foreign investors. Yet how far and how fast rates actually rise are critical considerations for the dollar's fortunes.

Interest rate hikes blunt business growth and raise yields on U.S. debt. Since foreign investors must buy dollars to purchase U.S. stocks and bonds, a large enough rate hike conceivably could torpedo U.S. equities, debt and the dollar.

"In general, I think this is what people are afraid of," said Marc Chandler, chief currency strategist at HSBC in New York. "It just comes from (the market) being more convinced that the (Federal Reserve) is going to raise interest rates."

Expectations for higher rates to ward off nascent price pressures have been growing thanks to signs of improvement in the U.S. economy, particularly in the labor market.

Fed Chairman Alan Greenspan bolstered those expectations this week when he said higher rates may be needed to guard against inflation since the economy is expanding vigorously, but said he did not see broad price pressures surfacing yet.

The questions for forex traders remain, however: When? How much? And what effect will it have on U.S. assets?

"It's a relevant question," said Jeremy Fand, senior proprietary trader at WestLB in New York. "It is possible the Fed needs to be careful about raising rates too aggressively."

2004 COULD ECHO 1994

Analysts who are concerned the Fed may raise rates too high too fast point to events in 1994 as a precedent. In February of that year the Fed ended a long period of ultra-low interest rates and began a tightening cycle that saw the fed funds rate increase by 3 percentage points by February 1995.

That rapid-fire tightening made mortgage and commercial borrowing much dearer, weakened the stock market and sent bond yields up more than 2 percentage points in a matter of months.

U.S. assets became less attractive to foreigners and sparked a 15-month decline in the dollar.

Analysts are alert to the potential for a repeat performance, even if they don't necessarily expect one.

The 2004 economic recovery is less robust than the recovery of 1994, however, making aggressive rate hikes unlikely.

Analysts also said the Fed may want to push rates higher now so that they have room to ease later if necessary.

"One difference this time is that rate hikes are not going to be to restrain growth," Chandler said. "It's more to normalize monetary policy", in case some kind of global security crisis were to spark the need for a rate cut.

Fand noted Fed officials have recently signaled the U.S. central bank does not want a rate hike to interfere with the robust housing market, consumer spending or job creation. The Fed also may be reluctant to raise rates ahead of the November presidential election for fear of seeming to sway the outcome.

DATA SHOWS RENEWED DEMAND FOR U.S. ASSETS

Analysts said fresh overseas demand for U.S. assets has supported the dollar. U.S. Treasury Department data this month showed that foreigners purchased a net $83.4 billion of U.S. assets in February, down from January, but still healthy.

Purchases of U.S. Treasury bonds continued to outpace stock buying, which declined sharply in February from January.

Analysts said, however, that foreign investors could be scared away from the U.S. debt market if the Fed were to indicate a willingness to raise rates steeply.

"You may start to see some selling now, but only if the Fed indicates aggressive tightening," said Paresh Upadhyaya, portfolio manager for currencies at Putnam Investments in Boston. "I would say your private sector flows would be more sensitive to changes in the interest rate outlook."

Upadhyaya saw no reason for the Fed to mount a quick-fire tightening campaign at the moment, so for now, traders should anticipate a bullish dollar reaction to any U.S. rate hike.

Source: Reuters News Service