New Dollar Update

The bullish dollar case I argued remains intact as February draws to a close. The bull case was based on a conviction of the underlying resilience of the US economy, which in turn would prompt more Fed tightening that the market appreciated. Widening interest rate differentials would lend support to the greenback.

At the end of last year, the market has discounted a 4.75% peak in the Fed funds rate. Second thoughts were seen in January. The July Fed funds futures contract is finishing Feb about 30 bp below when it finished last year as the market anticipates a 5.00% Fed funds at mid-year.

Great Another G8

Hosted by Russia, the leading industrialized nations will meet this weekend. There is no reason to expect new initiatives that would impact the global capital markets and especially the foreign exchange market. Energy and Iran appear more salient for policy makers than the markets per se.

There was trial balloon floated by the US for the IMF to take on a greater role in monitoring the foreign exchange market, but there are all kinds of practical difficulties, even if it finds conceptual agreement. Given that a number of loan recipients have made back their debt early and no new programs have been initiated, we need to be careful of mission creep. On practical grounds, it seems difficult to have operational definitions and appropriate time-frames. For example, China has taken numerous steps over the past 6-8 months that appear to be in the desired direction, including a basket approach and a band, a market-making system and new rules on interest-rate swaps. Many officials, especially in the US and Japan, want China to accelerate its moves, but the message is mixed.

Dollar Bull Case Updated

Last week we outlined a bullish case for the US dollar. It was predicated on US economic data confirming that the soft Q4 05 GDP was a fluke and that the economy was off to a sufficiently robust start of the year to absorb more the diminishing slack in the economy. This in turn would compel the market to re-think the likely trajectory of Fed tightening, interest rate differentials would widen and the dollar would strengthen. This is largely what happened over the past week and there is reason to expect additional dollar gains in the period ahead.