The prospect of changing interest rate regimes in the world's largest economies is throwing the direction of global currency flows into question.
For the most part, 2005 has been the year of the dollar, which has been driven higher by various factors, among which favourable interest rate differentials have been key. It is up more than 15 percent versus both the euro and yen.
Whether this flow continues is now in doubt, however, courtesy of global central bank musings. Next year could bring a weaker dollar and a stronger euro and yen.
This much is known:
The US Federal Reserve is embarked on a steady, measured, tightening cycle that has increased rates to 4.0 percent from 1.0 in June 2004. But it has also begun pondering ways to tell markets it is going to stop.
The European Central Bank is about to start. It has all but announced it will tighten next week, lifting rates from the 2.0 percent level they have been at for more than two years.
ECB President Jean-Claude Trichet has signalled, however, that the bank is not planning to follow the Fed's aggressive climb up the ladder.
The Bank of Japan has signalled it is close to ending its policy of zero interest rates and flooding the market with excess liquidity. But it has set conditions for doing so and interest rates are likely to remain very low.
This presents investors with three banks tightening, two just starting and one about to pause. Add Britain, which is on hold but leaning to a cut, and you have a series of difficult calls.
"It is a lot easier to make a currency call when one country is raising rates and the other is cutting," said Stewart Newnham, currency strategist at Morley Fund Management.
Directions are understood, but what is not known is when and to what degree the banks are going to act, and in this - not for the first time - the Fed is the key.
It is widely expected that the Fed will stop its tightening cycle after peaking at anything between 4.50 percent and 5.0 percent by mid-2006.
That point, or the period leading up to it, is expected by many investors to mark the end of dollar strength driven by cyclical factors and the beginning again of dollar weakness driven by fundamentals.
"The US current account deficit will start to become something of an issue again and ... that will be a drag on the dollar," said Sarah Hewin, a senior economist at American Express Bank.
For currency markets, the tipping point looks like this:
The Fed stops hiking, removing a key driver that has pushed the dollar higher. This takes attention off rates and onto the current account deficit, which is increasingly in need of funding from abroad.
At the same time, the euro zone has higher rates than now and is either on hold itself or leaning towards hiking. Japan at that point is attracting flows because of its solid economic renaissance and a potential tightening.
The dollar is also likely to get hit - possibly sooner rather than later, say some analysts - by the end in December of corporate profit inflows under the Homeland Investment Act tax amnesty.
Moves by other central banks are less critical, in part because the Fed is the biggest beast in the jungle and in part because tightening elsewhere is not expected to be as pronounced or lengthy as the Fed's.
The euro soared on November 18, for example, when Trichet indicated that the bank was about to hike, but fell sharply on November 21 when he said it was not going to adopt a Fed-style tightening cycle.
The timing of the Fed pause, therefore, has become the fixation of many investors because it could dictate when and how far the dollar begins a decline and other currencies start to rise.
Amex, for example, believes the Fed will stop in the first quarter after taking rates to 4.50 percent or 4.75 percent. It sees the dollar rising a bit then diving to $1.25 per euro three months from now, a more than 6 percent fall from current levels.
Comments
Comments are closed.