US rates outlook boosts dollar

Euro

The dollar commenced the week on a positive note after a run of surprisingly upbeat data eased worries that the United States may not attract enough capital to fund its huge external deficit.

An above consensus rise in new jobs and retail sales in April and a narrower-than expected trade deficit in March fuelled buying in the dollar, pushing the single currency below major support levels this year.

However, luck soon shifted hands as the dollar was subjected to selling pressure after the release of a report showing capital flows into the United States shrank in March to the lowest since October 2003. The $45.7 billion net inflow into U.S. securities was not enough on its own to cover the month's $55 billion trade deficit and was way down from a revised $84.1 billion in February.

The two-week dollar rally ran out of steam after a weaker-than-expected U.S. core consumer inflation report for April, made it less likely the Federal reserve will become more aggressive in raising interest rates. The core consumer price index, which strips out food and energy costs, was unchanged from March, giving the first flat reading since November 2003.

However, on the last trading day the dollar rallied to fresh highs after its resilience to potentially damaging developments this week triggered a technical breakout. U.S. economic and inflation data, as well as falling U.S. bond yields, failed to hurt the dollar, reflecting the market's growing bullish sentiment towards the currency.

A belief that U.S. interest rates will remain on their upward course, widening the gap with lower European rates, helped the dollar, while political and economic concerns in Europe weighed on the euro.

Most players still expect the Fed to continue its tightening campaign, which would widen the dollar's rate advantage over other major currencies. Eight straight interest rate rises to 3.00 percent since last June have helped outweigh worries about rising trade and budget deficits.

In contrast, the European central bank is set to keep interest rates steady at 2 percent this year given the sluggish growth in the euro zone. Sentiment towards the euro deteriorated as eurozone economic data continues to come in on the soft side and as political risks also weigh on the single currency.

The French referendum on the new European Union constitution later this month might reject the treaty, while state elections in Germany's largest state this weekend could result in the defeat of the governing coalition.

In the coming week, investors will scrutinise Federal Reserve minutes and U.S. price data to see whether the Fed will maintain the steady pace of its interest rate rises. Germany's ZEW economic sentiment and Ifo business climate figures will throw light on the outlook for the euro zone's biggest economy.

Meanwhile, the French referendum on May 29 will be closely watched, with European policy makers warning that a rejection would have negative economic consequences and analysts expecting the euro to take a temporary hit.

Range for this week: $1.2450-$1.2750

Yen

The Japanese yen got a brief boost in early trade and hit a three-month high against the pound after data showed the Japanese economy grew at its fastest pace in a year in the latest quarter, more than double forecasts.

The U.S. currency came under pressure against the yen on expectations that the Bank of Japan might tweak its easy monetary policy to allow a temporary breach of its fund supply target. Adding to the dollar's woes were comments from South Korean central bank governor Park Sueng, that he did not anticipate the country would increase the amount of its foreign reserves.

But the central bank said that it was ready to take action if the currency markets showed signs of instability. The greenback was further put to test after comments from U.S. Treasury Secretary John Snow who stated China must increase flexibility in its currency or risk contributing to global fiscal imbalances and raising the chances of a "boom and bust" cycle in their own economy.

Meanwhile, investors were caught off guard after Hong Kong Monetary Authority said it would tweak the territory's currency peg to fend off upward pressure on the Hong Kong dollar from speculation over possible revaluation of the Chinese yuan.

The HKMA said it would refine the operation of its exchange rate linked to the dollar, setting a trading band for the local currency between HK$ 7.75 and HK$ 7.85 per U.S. dollar.

The U.S. unit made a major come back versus the Japanese yen on the last trading day testing a one month high of 108.28, consolidating gains made on an increasingly upbeat view of the U.S. economy. Investors will however, be on high alert for any announcement by China on a revaluation of its pegged yuan currency.

Senior Chinese officials are due to speak at a China Economic Summit in Beijing on Tuesday and Wednesday. Japanese consumer prices due on Friday is expected to show Japanese consumer prices fell 0.3 percent in April, extending a seven-year decline.

Range for this week: Y106.50-Y109.50

Sterling

Sterling crashed to six month lows against the dollar as the greenback rallied across the board on expectations that U.S. interest rates are set to rise further.

In contrast, investors are pricing in the possibility of a British interest rate cut following weak economic data. The Bank of England raised interest rates five times between November 2003 and August 2004.

The release of soft British pay growth data and minutes showing only one BoE member voted for a rate hike in May, dented the pound. The data confirmed increasing market expectations that the next British rate move will be a cut, driving sterling to its lowest level since late March against the euro and six-month lows against the dollar.

Range for this week: $1.8100-$1.8400