The Dollar Is Flexing Its Muscles

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The Dollar Is Flexing Its Muscles

May 17, 2005, 11:34 PM (GMT+02:00)

The US dollar finished last week’s trading at its highest level in six months against the euro (1.2620 euro per dollar). It also made a strong showing against all other major world currencies.

Another round of good economic figures – especially the surprise narrowing of the American trade deficit in March, as published on Monday, May 11 – was a contributing factor. Other boosters were the slide in oil prices, the continuing surge in dollar interest rates, the huge speculative closing positions of the punt (=gamble), wagering on a revaluation of the Chinese currency, and the weak economic figures coming out of Europe.

DEBKAfile’s financial analyst sees the dollar emerging from the trough into which it began sinking in 2001 and expects a steady climb from now on and in the long term.

The reasons behind this improvement are enumerated here:

1. Favorable US economic figures

A key structural cause of the dollar’s decline, the American trade deficit, shrank to $55 billion, overtaking the pessimistic estimate of $62 billion. This is still disturbingly high in absolute terms, but it points to change around the corner. Further progress is will come from declining oil prices.

April retail sales jumped 1.4%, better than expected. While this indicator is notoriously volatile, still many economists regard it as a sign that the American economy is becoming more robust and coming out of the soft patch of the last few months.

April employment figures showed an additional 274,000 new jobs. Taken with the higher revision of the last two months, these figures confirm that the labor market is expanding and the American economy growing.

2. Declining oil prices

Oil prices dipped by a sharp 4.5% last week, ending at $48.5 per barrel.

This is the outcome of the continuous topping up of US oil inventories, which are assured of meeting the rising summer demand. Following up on his prediction last August of rocketing oil prices, DEBKAfile’s financial analyst now sees this trend leveling out.

3. Massive speculation on revaluation of the Chinese currency

Expectations built up in financial markets in recent weeks for the long-awaited revaluation of the Chinese yuan to eventuate very soon.

American and European leaders issued insistent calls for Beijing to fluctuate its currency which has been pegged to the dollar for almost a decade. Among them were Alan Greenspan, chairman of American Federal Reserve Bank, and president George W. Bush. They demanded Chinese currency revaluation against other major currencies to give their countries a fair chance to compete with the burgeoning Chinese economy.

Under the influence of high expectations for yuan reform within weeks or even days, major financial institutions engaged in huge speculation: dollars were sold briskly and Asian currencies purchased, primarily the Japanese yen. (The Chinese Yuan is still not fully tradable on financial markets). Then came a strong denial from the Chinese central bank that forced many of the punters on revaluation to close their positions. They went into reverse, buying back dollars – mainly against the yen. In only three days of trading, the dollar jumped by 2.3%: from a low of 104.90 yen per dollar on May 11, to 107.30 per yen at week’s closing Friday, May 13.

In the meantime, muscles were flexed. Chinese premier Wen Jiabao sternly informed visiting US Chamber of Commerce visitors to Beijing Monday, May 16, that reform of the yuan is a matter of Chinese sovereignty and any pressure or speculative exploitation of the issue will not be conducive to resolving it.

The US Treasury Department riposted Tuesday, May 17: “Current Chinese policies are highly distortionary and pose a risk to China’s economy, its trading partners and global economic growth.” Beijing was accused of coming close to manipulating its currency to gain an export advantage last year. The word sanctions appeared in the US communiqué.

DEBKAfile’s financial analyst is certain that political upmanship aside, the Chinese will have no choice but to fluctuate their currency in the short term. They will seek advantageous timing, such as the August summer vacation time or year’s end.

4. Higher short-term dollar interest rates

At the last US Federal Reserve meeting, on May 3, Greenspan said upon raising the short-term interest rate by 0.25%, "rate hikes will keep on at a measured pace"

Rising dollar interest rates, expected to spiral by year’s end to 3.75-4%,will make dollar sales less attractive. Already now dollar purchases against the euro produce positive interest differentials of 1.5% on yearly basis.

This provides the dollar buyer with positive carry trade. Long term strategic investors will take into account these positive interest rate differentials when they select their preferred currencies and investments.

The main peril for the dollar in the medium term is from non-economic world developments, especially UN Security Council sanctions to punish Iran for its nuclear program. This is why Europe and the United States are leery about referring the issue to the world body. They take into account that sanctions against one of the world’s biggest oil producers could send oil prices shooting up and hurt the dollar. US military action against Iran may well set the dollar back to its lowest level as well as damaging the world economy. Any major terrorist attack in the United States or attempt on the life of an American leader would have the same ill effect.

To sum up, a spate of positive US economic figures, higher dollar interest rates – some even breaking through key technical support levels – have given the dollar bounce.

On May 13, the euro traded at new yearly lows against the dollar: $1.2620 $ per euro. The US currency is pulling itself out of its low ebb of 2001 and is poised for fresh vigor in the long term

In the medium and short term, the euro might find some support against the dollar at $1.2550 and $1.24 per euro, resistance levels expected at $1.2730 (last year’s low), and $1.2920. But as long as the euro is trading below $1.30-1.3050, we still can define a stronger dollar trend for the medium term with an eventual m/t target of $1.18-1.20. In the long term, we might again see the euro level with the dollar, but that will take more than a year.

As one Swiss strategic consultant told DEBKAfile: “I cannot tell you in what year it will happen, but it will.”