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Greenback takes surprise hit on fears of tough year ahead
Steve Johnson, FT Syndication Service
12/26/2005
LONDON: Currency traders hoping for a spot of quiet pre-Christmas dealing had a nasty shock this year as dollar bears came out of hibernation.
In recent days the Japanese yen -- the whipping boy of the global markets in 2005 -- has surged against the US dollar, hitherto the surprise star of the year. The latest 4.1 per cent rally was the yen's biggest one-week gain against the greenback since November 1999.
Hedge funds, which had built up big long dollar/yen positions in the expectation that 2005's trends had further to run, were forced to sell dollars and buy yen to salvage their profits. As a result, the dollar also fell against the euro.
The dramatic moves, according to some, may not have been a one-off correction but a sign of things to come in 2006.
For Jens Nordvig, currency strategist at Goldman Sachs, the moves suggest currency markets are already in the grip of new themes. "The market has been forward looking."
Kevin Grice, senior economist at American Express Bank, said. "It looks like the start of a sustained pullback [by the dollar]."
Almost all strategists predict the dollar will be in for a much rougher ride in 2006 as it resumes the downtrend it started after the dotcom bubble burst in 2000. But the fall is unlikely to be a continuous one. After all, many traders predicted steep dollar declines this year.
Analysts say that was because interest rate differentials moved strongly in the dollar's favour as the Federal Reserve increased US rates eight times, raising the yield on US assets relative to those of other major trading blocs -- namely Europe and Japan.
The impact of the rate differential was bolstered when worries over the size of the US current account deficit eased as the deficit itself appeared to stabilise.
The dollar was also buoyed by the Homeland Investment Act, a one-year tax break designed to encourage US multinationals to repatriate accumulated profits held overseas.
But unfortunately for dollar bulls, all three factors now appear to be turning.
Interest rate differentials may indeed edge a little further in the dollar's favour, but the scope for tighter monetary policy is now greater in low-rate blocs such as the eurozone, Japan, Switzerland and Scandinavia. Meanwhile the repatriation of funds under the Homeland Investment Act is expected to peter out as the legislation expires and there are signs that the US trade deficit is set to resume its upward path. The deficit hit a record $68.9bn in October.
Goldman believes the potential coup de grāce for the greenback will be the peaking of US interest rates at 5.0 per cent next year.
It expects rates to then fall to 4.0 per cent as growth slows in 2007, a factor the currency markets should begin to price in next year.
Mr. Nordvig says he also expects the trade deficit to balloon in 2006 as this year's dollar strength exacerbates the trade gap with a 12-18 month time lag. He insists it is "important not to extrapolate some of the trends of 2005 into 2006. The foreign exchange market very rarely works that way,"
Merrill Lynch also sees the latest dramatic turnround as a sign of things to come in the currency markets. Merrill believes "Anglo-axon" currencies, such as the US, Australian, New Zealand and Canadian dollars, as well as sterling, will underperform next year as interest rates peak.
The winners, according to Merrill, will be the euro, yen and Swedish krona as global interest rate differentials narrow.
Deutsche Bank too predicts the "structural downtrend" of the dollar will resume as worries over the external and budget deficits of the US return to the fore.
It has pencilled in end-2006 dollar forecasts of $1.27 to the euro, compared with $1.188 now, and Y102 to the yen, against Y116.58.
Expectations for future US rate rises were further damped late last week by the release of softer than expected November inflation data. This prompted Ian Stannard, currency strategist at BNP Paribas, to say: "I believe we are at the turning point for the dollar. The market is starting to speculate that rates may have to start coming down towards the end of next year. We are seeing the dollar gains of the past year starting to end."
ING also foresees dollar weakness in 2006, forecasting rates of $1.30 and Y105 in 12 months' time. However the Dutch bank perhaps unwittingly offers grounds for hope for the dollar.
Dollar bears were in the ascendancy at the start of 2005, leaving few marginal sellers to push the greenback lower still, says Chris Turner head of forex strategic research. That very same scenario could yet be repeated in 2006.
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