The dollar could emerge stronger from a potential global economic slowdown if investors carry on shrugging off the Federal Reserve's credit tightening pause and seek safety in highly liquid US assets.
A serious decline in US consumer demand would hit countries such as Germany and Japan which depend heavily on exports to the United States, steering investors back to US assets, said Constantine Ponticos, managing director of research at Pareto Investment Management.
"If the US slowdown translates into a global slowdown, then that's not necessarily going to be bad for the dollar," said London-based Ponticos, whose firm oversees $54 billion in assets and advises the California Public Employees' Retirement System, the largest US pension fund, on currency risk.
"Particularly in Europe and Japan, the healthiest part of the economy has been the export sector and the most important final destination for these exports has been the US"
US Treasury securities in particular would likely rally in the event of a global slowdown barring a major inflation shock or an unexpected capital flight, Ponticos added.
Federal Reserve policy-makers left interest rates steady at 5.25 percent at their meeting last week, the first time they have taken a pass since June 2004. Fed Chairman Ben Bernanke has made it clear that he expects slowing US economic growth to moderate inflation pressures.
The combination of sluggish US growth and a Fed pause is seen by many analysts as a very sharp thorn in the dollar's side, especially since the United States needs more than $3 billion in foreign investment every working day to plug its current account deficit. But Ponticos said easing in energy prices could also help improve the fundamentals that underpin the greenback.
"The US economy is going to slow down to trend growth or lower and may even go into a recession," Ponticos said. "However, barring policy errors by the Fed, if energy prices fall, that would do a lot to take the pressure off household finances," he said.
In addition to current high energy prices, the rapidly decelerating US housing market is dragging growth in gross domestic product down from unusually high rates at the start of the year and prompting Fed policy-makers to keep rates steady while they asses the economy. GDP is seen slowing to around 3 percent in 2007 from 3.5 percent this year, according to a Reuters poll.
But the Fed's 425 basis points of cumulative monetary policy tightening since June 2004 has provided the dollar with a cushion, particularly against the euro and the yen, Ponticos said. In both the euro zone and Japan, where overnight interest rates lie at 3 percent and 0.25 percent, respectively, monetary authorities have only recently begun to lift interest rates.
After rising 13 percent in 2005, the dollar has slipped 6 percent against a group of major currencies so far this year. Since the Fed's August 8 meeting, however, the dollar index has gained 0.63 percent.
While Ponticos said he mainly focuses on G10 currencies, one wild card in his outlook for next year is the extent to which large emerging market countries liberalise and reform their respective economies and allow in more foreign investment.
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