Jul 2004 Financial News

US Dollar Slides vs. Euro, Pound, but Edges Higher vs. Yen

Jul 01, 2004

Dow Jones Newswires

NEW YORK -- The dollar declined against most of its major counterparts Wednesday in trading marked by the Federal Reserve's widely anticipated decision to increase interest rates for the first time in four years.

While most of the dollar's losses came before the quarter-percentage-point increase was announced, the well-telegraphed launch of the U.S. monetary- tightening cycle stirred little enthusiasm for the fortunes of the embattled dollar.

The prospect of gradually rising interest rates in the U.S. is a clear sign of optimism about the strength of the economic recovery, but the currency market remains split on whether tighter monetary policy will attract enough foreign investment to cover the financing needs of the massive U.S. current account deficit. Lingering uncertainties about the economy -- as well as jitters over terrorism and the 2004 presidential election -- also continue to cloud the dollar's outlook.

Record U.S. trade gaps and a slide in the federal-funds rate to a 46-year low of 1% have conspired in recent years to weaken the dollar, culminating in the euro's all-time high against the U.S. currency above $1.29 in February. Low U.S. rates also made the dollar an attractive funding currency for the so-called carry trades -- in which investors borrowed in cheap dollars to acquire assets from countries with higher yields, putting further pressure on the U.S. currency.

On Wednesday, the Federal Open Market Committee lifted the benchmark federal- funds rate to 1.25%, and reiterated that with inflation expected to remain " relatively low," the pace of tightening "is likely to be measured."

Some analysts believe that as the difference between yields in the U.S. and countries with higher interest rates narrows, the dollar can finally pull out of its long-term downtrend. Indeed, the currency's broad-based recovery in the spring, which has resulted in a loose range in the euro based around $1.20, has been largely attributed to hopes for higher rates in the U.S.

Late Wednesday, the euro was trading around $1.2191, above $1.2080 late Tuesday in New York. The single currency hit a two-week high of 133.43 yen before settling back to 132.75 yen, still well above 130.90 yen. The dollar also reached a two-week high of 109.58 yen, but gave up much of its gains following the Fed decision. It traded late in the day around 108.91 yen, compared with 108.35 yen late Tuesday.

Sterling rose to $1.8183 from $1.8070, while the dollar fell against the Swiss franc to 1.25 francs from 1.2658 francs Tuesday. Against the Canadian dollar, the dollar fell to a 2 1/2-month low at C$1.3329, compared with C$1.3446 late Tuesday.

Peter Frank, senior foreign-exchange strategist at ABN Amro in Chicago, said a future of incremental rate increases is "relatively positive but not a screaming buy" signal for the dollar. The greenback's path appears to be "easy as she goes," he said. "The economy is doing very well, disinflation has gone, but there's not an ugly inflationary shock around the corner."

With this generally positive backdrop, the dollar should do well against currencies from countries with struggling economies, such as the euro, or those who have already tightened policy significantly, such as the Australian dollar. But Mr. Frank advised against betting against currencies from more dynamic economies that hold the prospect of surprise rate increases, such as the yen or Canadian dollar.

Others believe the dollar needs more than well-flagged moves from the Fed to break out of its recent slumber. There is a lot of capital waiting to be plowed into the market, but investors won't jump in until clearer trends emerge.

"As the Fed moves along in its gradualized approach, that's not particularly supportive for the dollar," said David Durrant, chief currency strategist at Bank Julius Baer.

A rising rate environment typically isn't constructive for equity markets nervous about a slowdown, and U.S. yields aren't expected to rise enough to compensate for building inflationary pressures to make U.S. bond markets an attractive place to invest, either, he said.

Consequently, the start of the rate cycle does little to improve the outlook for the dollar. What has changed, however, is the dollar's usefulness in a carry-trade strategy.

"The dollar as a funding currency has gone by the wayside," said Mr. Durrant.

That would mean higher-yielding currencies such as the Australian dollar have lost their sheen. Instead, the yen should be a favorite, while the euro stands to continue to bounce around in a range, he added.

Further out on the risk spectrum, emerging-market currencies will also remain vulnerable to the threat of a more aggressive Fed policy, which could choke off global liquidity and send investors scrambling out of peripheral markets.

Noting the allure of higher yields, Mr. Durrant said investors should remain cautious but not "necessarily exit those markets." He anticipates some " compression of spreads," and thus better emerging-market bond and currency performance, "as long as the Fed moves along in a slower pattern."

The initial reaction to Wednesday's decision has been muted, with the dollar remaining around lows for the day against most counterparts that were reached a little ahead of the announcement. But sentiment could shift quickly depending upon the tone of upcoming U.S. data.

An unexpected decline in the Purchasing Management Association of Chicago's index of area business activity, to 56.4 in June from 68.0 the month before, raised concerns about Thursday's broader measure from the Institute for Supply Management. The ISM manufacturing index is expected to ease to 61.5 in June from 62.8 the month before in Thursday's report.

However, the highly anticipated June U.S. payroll report Friday could be another blockbuster, with economists surveyed by Dow Jones Newswires coming up with a consensus view that 250,000 jobs had been created this month.

-By Tom Barkley, Dow Jones Newswires; 201-938-4385