Dollar depreciation likely to resume

Yield factors will remain very important in the short term, and confidence in further U.S. interest rate hikes will offer dollar support, especially as the higher yield structure will discourage speculative selling.

The market has, however, already factored in further rate increases, which will make it more difficult for the U.S. currency to secure fresh buying interest.

Also, growth will likely falter as consumer spending comes under pressure; this would trigger a significant deterioration in dollar sentiment as markets would anticipate a peak in U.S. interest rates.

Although the dollar’s structural weaknesses tended to be of secondary importance over the past two quarters, they certainly should not be ignored. The high U.S. current account deficit will sustain the risk that dollar confidence will crumble, while underlying central bank reserve diversification away from the U.S. currency will continue. (For an in-depth look at central bank diversification, read “Foreign exchange reserves — the who, what, and why,” in the January 2006 issue of Active Trader magazine, which will be available in December.)

In the short term, market forces are likely to be near balance, limiting dollar moves, with a 1.1870-1.22range in the Euro/dollar rate realistic, and the Euro likely to gain support from a tough European Central Bank (ECB) stance and potential rate increase this quarter. Once the capital repatriation flows stop toward the end of 2005, the dollar will be much more vulnerable to any shortfall in capital inflows, and this could be decisive in pushing the U.S. dollar lower. Late in the fourth quarter, dollar losses toward 1.25 are likely.