Dollar decline seen dominating markets in week ahead

By Jeremy Gaunt
Reuters
Sunday, March 2, 2008

http://www.reuters.com/article/etfNews/idUSL2922804820080302?sp=true

LONDON -- Currencies will be in full focus on financial markets this week following the dollar's drubbing of recent days yet anyone hoping for help from policy makers to shore up the ailing greenback is likely to be disappointed.

Key meetings of European Union finance ministers and European Central Bank interest-rate setters are expected to do little to shift the status quo, while the U.S. Federal Reserve appears dead-set on cutting again this month.

"I don't see a major change in trend this week", said Lex Hoogduin, chief economist at Dutch investor Robeco.

This means that gold and oil prices should maintain their record-breaking pace at least over coming days, while equity and bond investors will have to continue revaluating their holdings in light of a soaring euro and low-yielding dollar.

It may also put strains on export-oriented emerging Asian stock markets, which have otherwise started to see an increase in institutional investment flows.

The dollar took many investors by surprise last week, falling to an all-time record beyond $1.50 to the euro, meaning that the 15-nation currency has strengthened around 15 percent against the greenback over the past 12 months.

Less heralded, but by no means less significant, the so-called dollar index (DXY), which tracks the U.S. currency against six major counterparts, hit its lowest level since inception in 1973.

While many institutional investors believe that the dollar will recover some strength by the end of this year, there is no conviction that this will happen soon.

"The trend in the short term is for more dollar weakness," said Colin Asher, senior economist at investment bank Nomura.

... Different rates

A key reason for this is that the background dynamics that have pushed the dollar lower -- specifically interest rate differences -- are unlikely to change in the next few months, let alone in the week to come.

ECB rate-setters, for example, have made it clear that they are more worried about inflation than a slowing economy. All 72 economists in a Reuters poll last week said the ECB would leave rates at 4.0 percent when it meets on Thursday.

European policy makers are also unlikely to be overly concerned about the euro because its strength makes imports cheap, putting a damper on the inflation that so concerns them.

By contrast, U.S. Federal Reserve Chairman Ben Bernanke clearly signalled last week that the U.S. central bank will cut rates again to stop further damage to the ailing U.S. economy.

The Fed is widely seen cutting U.S. rates by at least 50 basis points to 2.5 percent at its next meeting on March 18 .

This leaves currency markets hostage to a raft of U.S. data this week -- including on manufacturing, services, jobs and vehicles sale -- which are expected to be poor overall.

The question may then be "how far will the dollar fall", although Nomura's Asher noted that with the dollar already so weak a bit of a bounce cannot be ruled out.

Profit-taking and better-than-expected data can always turn things around quickly, particularly in an era of overall global market volatility.

...Spillover

For equities this week, the weak dollar provides a mixed picture. It has little short-term impact on many U.S. equities, which tend to be domestic in orientation, but shakes the more export-focused markets of Europe and Asia.

"It should hurt European equity markets more than it will help U.S. equity markets," said Klaus Wiener, chief economist of Generali Investments.

Stock markets, he said, will be focused on plans to rescue U.S. monoline insurers, the firms that insure structured finance whose potential downgrading as a result of credit market turmoil threatens to spill over into other parts of the financial sector.

The volatility on currency markets, meanwhile, comes as equity markets have been rallying relatively sharply.

MSCI's benchmark world stock index, incorporating U.S., European, Japanese, and emerging market shares, is up around 8 percent from a low on Jan. 22, the day the Fed announced an emergency rate cut to boost the U.S. economy.

Where a weak dollar most certainly has an impact, however, is with commodities, notably gold and oil.

Because these assets are priced in dollars they rise when the currency falls as they become more attractive for non-U.S. investors. In both cases, this has added to their already soaring demand driven prices.

Gold hit a record high around $975 an ounce on Friday, leaving the psychological $1,000 milestone within sight this week. Oil, meanwhile, breached a new high of $103 a barrel.

The rub is that such prices fire up inflation, making central bank decision making that much trickier.

"The current inflation is due primarily to commodity prices of oil and energy and other prices that are being set in global markets," the Fed's Bernanke said last week.

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