Rate expectations buy time for USD

First it is important to note that dollar rebounds of around the 8% magnitude we have seen so far this year are not inconsistent with a sustained dollar bear trend, with two similar false dawns registered since the dollar began its decline in February 2002.

Nonetheless, we are aware that three key factors may mean the nature of this dollar rally could be different and more sustained than the previous two failed attempts: 1) Rising US interest rates; 2) China's attempt to cool down; and 3) Record oil prices hurting Asia

However, after careful debate and consideration we still conclude that these three factors are unable to mask the structural imbalances that will weigh negatively on the dollar, particularly in Asia.

For one, interest rate tightening of up to 100bps is already being discounted by the markets for this year, with much more to come in 2005. Moreover, even with a 2% Fed Funds target rate, real interest rates may still be negative or too low to reward foreign investors for investing in rising US trade and fiscal deficits. At the same time, higher rates will only add to US borrowing costs, unless economic recovery can rapidly bring about higher fiscal revenues.

Second, we believe that China will be successful at engineering a 'soft' landing that could still incorporate a modest appreciation of the renminbi in Q3. Tempered and sustained growth would also provide the basis for continued support for commodity currencies such as the AUD, ZAR and CAD.

This leads us to the third point that rising inflation pressures, especially due to higher oil prices, may not be a one-way sell for Asian currencies against the US dollar as initially perceived.

If anything, record oil prices are exacerbating the US trade deficit and pressuring US corporate margins as much as Asia's. Finally, Singapore's unique circumstances demonstrate that Asia can opt for monetary tightening through exchange rate appreciation, rather than interest rate tightening.

We also need to closely monitor the CNY. Since the middle of last year we had held the view that there will be a gradual change in Chinese currency policy, moving to a wider band in the second half of this year. We maintain this view. For the moment it seems that the Chinese will leave their currency policy unchanged. But rising inflationary pressures highlight the need to remain vigilant.

USD Analysis:

Over the last year, low US interest rates, poor trade position and a weaker currency policy pushed the USD down. Now rate expectations have shifted and the USD has bounced. But currency policy and the trade deficit remain USD negative. The Fed hiking cycle is fast approaching, and history has a clear message in terms of the impact on the USD.

If there is a modest hiking cycle, as the Fed is currently signaling, then this can benefit the USD, as credible policy keeps the bond market relatively stable while stock markets can benefit from higher growth.

The risk is that either a slip back into recession or a sharp rise in inflation would hit US assets and the USD. USD gains may be limited with aggressive expectations being priced in.

Policy: The FOMC has made clear its intention to remove policy accommodation, though the pace is likely to be moderate.

A rise in long term inflation expectations would change this, and given the dominance of debt flows in the breakdown of private capital flows sharper rises in US Interest rates would hit the USD hard by unsettling bond markets.

The Congressional Budget Office's(CBO) projections for the fiscal deficit are for 5% of GDP for the next decade if the unrealistic assumptions of the administration are removed. Fiscal policy is likely to continue to be a negative factor for the USD.

Flows: The latest data on capital in flows reveals Asian appetite for US assets is back up to record levels. Japanese purchases makeup the majority of this. IMM positioning has moved almost completely flat in the latest week as speculators search for a clear direction. This
implies the USD can be vulnerable to renewed leveraged buying or selling in coming months.

Technical USD index: Though the long-term trend resistance 91.00 has been breached, further gain was constrained by the Bearish Divergence signal at 92.00/10. In addition, realisation of objective 90.50 (March issue) has resulted in an overbought state and we would caution downward correction risk in the near-term.

The 38.2% Fibonacci support 90.25/30 and trend support 89.60/65 will play important role in maintaining the bullish mode required to test92.00and92.30, where a weekly close sets the path for a topside scope likely to be limited to 92.95-93.75. Trading below 89.60 and 89.20 will undermine our bullish short- term view.

FX Forecasts:
Current Q2 04 Q3 04 Q1 05
Europe 1.19 1.25 1.29 1.25
Japan 114 105 95 90
Switzerland 1.30 1.24 1.19 1.22
UK 1.78 1.88 1.92 1.88