INTEREST RATES AND ECONOMY KEY TO DOLLAR’S FATE

June 28, 2006 06:10 AM

Interest rates and economic data have been two main drivers for the dollar in recent years and the same appears to be holding true for 2006. Fourteen consecutive interest rate increases since June 2004 lead the dollar to rally about 14% versus the euro and the yen last year. When will the tightening stop and the dollar decline? Some analysts say the tightening will continue into May of this year. “The Fed might delay the dollar decline,” says Naomi Fink, senior currency analyst at BNP Paribas. “But it is just a matter of time [before the dollar declines].”

Fink, who sees range bound activity in major currency pairs for the first half of the year, forecasts the euro/dollar to land around 1.29 at the end of the third quarter and around 1.32 by the end of the year (see “Ready for breakout?” page below). “Basically our dollar view is still bearish over the year,” she explains.

Brian Dolan, director of research at Gain Capital, also believes the dollar will fail to find a direction in the first part of 2006. Dolan, whose third quarter forecast for the euro/dollar is 1.17-½ for a lower level and 1.25 to 1.26 as an upper level, says, “Throughout the beginning of 2006 the U.S. dollar has seen fairly wide ranges and we do not expect to see a big trend in the dollar or euro until later in the year.”

While forex traders continue to follow interest rate news quite closely, economic data has been given a prominent role as well. And the focus on data was given even more attention after Federal Reserve Chairman Ben Bernanke indicated he wants a more “data dependent” monetary policy. And of course the question becomes: Which data should analyst focus on? Opinions differ, but Mark Smyth, currency analyst with Xpresstrade, points out housing numbers certainly are high on the list. He says the housing market will be a key factor playing on the greenback this year. “A slow down in this vital sector could negatively affect the dollar.”

Dolan also says the housing market will be a major driver for how the dollar will behave throughout the rest of the year. “The U.S. housing market is critical,” Dolan says. “The dam has already been breached; the question is whether it will be a slow leak or a flood.”

In recent months, housing indicators have shown some signs of a cool down. For instance, the January new home sales report showed a 5% drop on the month to a 1.233 million unit annual pace, well below economists’ median forecast of 1.270 million units. Regardless though of whether the indicator is measuring the housing market, employment, manufacturing or anything else regarding the economy, many analysts agree with Dolan, “The euro and the dollar essentially will experience a range trading environment through the third quarter of this year until the fate of U.S. consumption and the U.S. economy becomes clear.”

Beyond economic data forex traders also have the price of oil to contend with. How will this year’s oil market shape the greenback? Smyth explains he is seeing a lot more correlation between the price of oil falling and the rise of the dollar. “Seventy dollar crude oil is a psychological negative for many traders, but anything below $60 [per bbl.], surprisingly as it might be, can be seen as helpful for the dollar,” he says.

A RISING YEN

While U.S. interest rates and economic data may be the key components to this year’s forex market, moves by other central banks outside of the United States are coming into sharper focus. In late February and early March all eyes and ears were on the Bank of Japan. Traders and investors carefully listened to comments from Japanese leaders, some of which strengthened expectations that the Bank of Japan would start paring back quantitative easing as soon as March or April. Signs that the country may be tightening its ultra loose monetary policy pushed the dollar below 116 yen in late February, which the market had not witnessed since the last week of January.

“It’s time,” explains Fink referring to comments from the Bank of Japan on making a policy change. Japan, which has struggled with deflation for the last decade and has experienced a weak economy for more than 15 years, is seeing more and more signals of inflation, according to Fink. “Japan has seen office rents go up, rises in the consumer price index and premiums on things like insurance. This is the first time Japanese investors have seen rises in these areas in the last two decades,” she explains.

And range trading again takes center stage. For the dollar/yen Fink sees range bound activity for the first half of the year, trading around 1.15 to 1.20. By third quarter she sees dollar/yen trading at 1.10 and around 1.05 by the fourth quarter.

According to Kevin Klombies, market analyst at TradingEducation.com, the yen will be the emerging star currency for the year, particularly against the euro. “The number one thing that has to happen for Japan to come out of deflation is that interest rates have to rise. It is not a recovering period if they don’t,” Klombies says. Overall Klombies sees a strong yen for 2006, a high U.S. dollar and forecasts other major currencies will trade lower.

EUROZONE CHANGES

European Central Bank (ECB) moves also surfaced as significant drivers on the forex market early this year. In early March, as expected, the ECB raised interest rates by 0.25% to a three-year high of 2.5%. “The grand scheme is an environment of U.S. interest rates nearing the end of a cycle and the European Central Bank just beginning,” Dolan says.

Originally analysts expected that ECB rates would move toward 3% by the end of the year, but more and more analysts seem to believe that the rate hikes may not follow in succession. Economic data coming out of Europe in late March certainly did not build the case for successive rate hikes. “There was a lot of speculation that 2006 may see a resurging of the Eurozone, particularly in Germany, but so far the European Union (E.U.) reform efforts are slow moving. The euro and dollar are essentially deadlocked,” Smyth says. However, he explains that if Eurozone fundamentals show marked improvement it is possible the euro could draw strength as the year progresses. The fundamentals that need improving include GDP growth, employment gains and consumer spending. Smyth adds the euro is unlikely to fall below the dollar this year.

As for a long term forecast on European interest rates, Klombies says, “European rates will swing back into 2007 and be higher than U.S. interest rates. At that time the euro will decline somewhere under parity — 0.95 to 1.0 as a target into 2007.”

CANADA’S PICTURE

Indeed, it comes as no surprise that the Canadian dollar’s future, like other currencies this year, also will depend on interest rate moves. “Canada has more room to go off of U.S. interest rates,” Dolan explains. “We are expecting two more hikes out of the Bank of Canada.” Fink agrees that Canadian rates still have a bit to go toward the upside. “This is good for Canada. We will see a favorable affect on Canadian savings. Instead of savings being recycled abroad, it is more likely to stay in Canada.” Fink forecasts the Canadian dollar to trade around 1.13 for both the third and fourth quarter.

Commodity prices also will be an important element in determining where the Canadian dollar lands this year, according to Smyth. “If crude oil prices rise we may see a rise in the Canadian dollar. It may then have another push and gain strength,” he says. However, Symth cautions that if the United States experiences a slowdown in its economy the floor may come out from under major currencies, especially those supported by Canada and Australia.

YUAN INFLUENCE

Another significant factor weighing on major currencies this year, particularly the dollar and the yen, is the possible further revaluation of the Chinese yuan. “Traders need to watch inflationary trends in China to gauge how likely it is for China to revalue,” Fink says.

The yuan experienced a rally very early in the year and then stalled. But in early March, the yuan strengthened past 8.04 to the U.S. dollar for the first time since July 2005 when China allowed the yuan to gain 2.1% against the dollar. While not all analysts agree, many still predict that a small series of daily price changes is more likely than a larger revaluation. Last year’s revaluation kept China from being named a currency manipulator in the U.S. Treasury’s quarterly review on exchange rate policies of U.S. trading partners.

However, the next report is due out in mid April and it has been reported members of Congress are saying the Treasury Department is moving forward with naming China a currency manipulator in the upcoming report. In addition, Chinese President Hu Jintao has planned an April visit to Washington, which is giving traders yet another reason to prepare for the potential for China to take another step and revalue further. In the meantime, analysts are forecasting the yuan to strengthen between 7.0 to more than 8.0 to the dollar for the next year.

Carla M. Bauch is a freelance writer in Chicago.

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