Greater US dollar weakness now forecast

The changes (relative to our already bearish US dollar view) are based on:

1. The heightened risk that the US pursues unconventional policies to combat the risks of deflation. This has been analysed in detail by Stephen King and Ian Morris ("Thinking the unthinkable: unconventional ways of fighting deflation"). All of the alternative policy measures would risk undermining the dollar further, perhaps severely.

2. The signs that global asset managers are showing an increased preference for the euro relative to the dollar. The dollar sales against the euro seen recently have largely been medium term in nature and are unlikely to be quickly reversed. The recent fall in the dollar does not, therefore, indicate a speculative excess that will soon unwind.

3. Official policy, to the extent that it was ever important, will clearly not resist further dollar weakness and euro strength. The US appears
intent on using all policy tools in an attempt to stimulate growth, and European officials do not (as yet) see euro strength as a major problem.

In fact, to the extent a higher euro helps cut inflation and allows the ECB to cut rates, it may be seen as beneficial for the Eurozone. The Japanese position is entirely different. The Japanese authorities are intent on trying to prevent yen strength through intervention. This is likely to continue, though we would not expect continued intervention at a fixed level whatever was happening to the dollar elsewhere.

The new forecasts for the major currencies imply a further 10% trade weighted dollar depreciation from current levels by end 2004, with most of the pressure being felt against the euro.