A bearish market factor

Buskas says reserve diversification is an important driver for the U.S. dollar. She suggests it will be one of the top three factors impacting currency movement in 2007.

“The big elephant in the room is China,” says BMO Capital Market’s Busch. “What are they going to do with their dollar reserves? It is one of the biggest unknowns out there in the capital markets.”

However, Busch notes that the U.S. Treasury department is actually working with China on how to proceed.

“The last thing the Chinese want to do is spark a dramatic dollar sell-off,” he says.

Some market watchers have suggested China and other global central banks will implement diversification tactics via incoming flows of funds, as opposed to outright selling of current holdings. And, given the roughly $200 billion new reserve funds projected for China on a yearly basis, this appears to be a realistic diversification strategy. Nonetheless, even a slowing of the current pace of foreign bank purchases of U.S. Treasury could in and of itself impact the U.S. interest-rate market and ultimately push rates higher.

Most analysts believe the Chinese will move cautiously in relation to any dollar reserve shifts.

“Sure there are concerns,” Fabbri says. “If central banks engage in this type of activity it will affect both [U.S.] interest rates and exchange rates.”

HSBC’s Lynch argues it should be a negative factor for the dollar.

“If they slow their purchases, it will create headwinds for the dollar going forward,” he says. Based on this bearish factor, he sees potential for euro/dollar to move toward $1.40 by year-end.

“It is not as though global central banks are going to begin a mass exodus of the dollar; it will likely be a slowdown of the rate of their dollar purchases,” he says.