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Currency & Money
US Dollar Outlook: Now Lies with the Federal Reserve
The fate of the US dollar now lies in the hands of the Federal Reserve. After having raised interest rates by 150bp over the past 8 months, the Fed has given dollar bulls good reasons to expect a continuation of the correction that we have been seeing in the EUR/USD since the currency topped out at 1.3667 on December 30th of last year. The dollar's depreciation throughout the past two years is directly linked to the Federal Reserve's interest rate cycle. The Fed has been lowering rates since the tech bubble burst in 2000. Interest rates have gone from a high of 6.5% to a low of 1% over the course of 3 years. This coincided with an 18% fall in the US dollar index over the same period. Between 2003 and 2004, the dollar continued to decline another 18% against the euro as countries such as the UK , Australia , and New Zealand all began raising rates while the Fed dragged its heels. Yet the tables have turned now, with the Federal Reserve being the only major central bank to raise rates aggressively in 2005. Most other central banks have either already finished tightening or only have no more than one additional rate hike left in the pipeline. With interest rates and expectations for interest rate changes being one of the primary drivers of currency movements, the narrowing interest rate differentials in favor of the US dollar could provide dollar bulls with a basis for optimism. Yet, this optimism will only continue until the Fed signals that they are done with tightening.
Continuation of Labour Market Growth Still Uncertain:
The labor market continues to be a big unknown for the US economy. Although non-farm payrolls have seen triple digit gains since August of last year, most of the months experienced below 150k job growth, which is the level that economists associate with the minimal job creation needed to meet the influx of new entrants into the labor market. Non-farm payrolls have also consistently disappointed consensus forecasts. Jobless claims point to a strong release, but the latest Challenger report of layoffs indicated that corporations continued to fire more employees last month. Additionally, although recent data from the Treasury indicates that foreigners have been helping to fund the deficit, a closer look at the data indicates that the Japanese, who are the largest holders of US treasuries, have cut purchases significantly or at times even been net sellers of US treasuries. With demand waning from this traditionally large purchaser, the dollar faces even more risks.
Possibility of Higher Cost Plagues Budget Deficit:
Although the US Administration promises to halve the deficit by 2009, over the near term, there is no evidence of proactive initiatives on behalf of the government to actually rein in the deficit. In fact, if the Administration's Social Security proposal gets passed, there could be an up to $1 trillion initial cost to develop the support network and system of privatizing social security. In addition, the recent rise in tensions with Syria , Iran and North Korea only further increases the risk of higher defense costs. As a result, in the immediate future, the budget deficit will only serve as another burden on the back of the dollar.
Successor For Greenspan Would Perfectly Coincide With End of Fed Tightening:
The end of Fed's tightening cycle should also coincide perfectly with increasing speculation of a replacement for Federal Reserve Chairman Alan Greenspan. After having served under four different Presidents of both Republican and Democratic Administrations, the Fed Chairman is expected to leave office at the end of January 2006. As one of the most respected central bankers of our time, Greenspan has managed to navigate the nation through 1987 Stock Market crash, the 1991 oil spike sparked by the Gulf War, the collapse of Long Term Capital Management in 1998, the burst of the NASDAQ bubble and 9/11, with only minimal setbacks for the economy. During his tenure as Chairman, US GDP increased in 16 out of 17 years - one of the smoothest periods of economic growth in US history. Therefore, it will be very difficult to find a replacement for the world's most effective and esteemed central banker. Right now, there has been minimal speculation for a replacement, but come late summer, early fall, talk of possible successors should be in full swing. With no successor possibly having as much respect as Greenspan has from the financial markets, speculation about who his replacement will be will only cause more uncertainty for the US dollar. This timing will coincide perfectly with the end of the Fed tightening cycle.
As such, with all the stars lining up around the same time, we expect to see the dollar's rally sputter and possibly even reverse 6 or 7 months down the line. In the meantime, the narrowing interest rate differential in favor of the dollar will play a big role in giving dollar bulls modest control over the greenback.
As for now the dollar is only benefiting from the Federal Reserve tightening process.
The Other Side: The Tankan Disappoints Japan
The headline business condition DI was unexpectedly weak for manufacturers, particularly for materials and electric equipment firms. Although this might reflect softer Asian demand, it seems out of step with recent bullish production plans. Non-manufacturing sentiment, meanwhile, remained firm with solid momentum at domestic-demand firms supported by localized land price gains and a rebound in personal consumption. These results provide further clarification of the divergence in manufacturing and non-manufacturing trends.
We are not that concerned about the weaker reading since corporate sentiment expressed in the Tankan (quarterly survey of business confidence) is a coincident or lagging indicator of actual economic conditions, and grass-roots sentiment, a leading indicator, is already improving.
We expect a rebound in the Japanese Yen to 104 levels from 107.50 levels in near term on following grounds:
l Growing optimism on Chinese Currency revaluation - China is a major trading partner of Japan
l Easing concerns on oil prices
l Dollar weakness to resume as soon as Fed tightening cycle is over
India Outlook and the Indian Rupee: A Solid Growth Ahead - New dynamism
Lower agriculture growth in FY 2005 would result in growth of 6% as compared to 8% in FY04. However, change in composition of GDP (agriculture output accounts for 20% today as compared to 40% earlier) coupled with key growth drivers of today (retail lending, infrastructure, outsourcing and demographics in whole), the outlook for India looks fundamentally strong and growth should be at 7% to 7.5%. This in turn would hold positive for the Indian Rupee currently at 43.80 levels. Infrastructure spending, led by road construction, would be one of the key sources of growth in days ahead. This would benefit sectors such as steel, cement and construction equipment as well as generate employment opportunities.
Competition and falling interest rates would allow for more expansion in retail lending - this would emerge as a key driver for consumption and banking services
l Apart from technology, new opportunities are in exports of automobiles, capital goods and pharmaceuticals
l Positive age, income and urbanization trends coupled with improved market access and better education would result in growing consumption.
Indian Rupee:
We have seen in the past month including this month that the India Rupee has been trading within a tight band making many intra day moves from a start of 43.77 with moving ahead to 43.88 levels. This pattern was mostly guided by technical rebound in the US dollar, with Federal Reserve signaling further rate hikes, higher oil prices; domestic demand for the US currency and FII's holding a move in and out policy on emerging markets investment for a few weeks. The Reserve Bank of India had abstained form any direct intervention but has been in the market on both the bid and offer side to contain volatility.
We remain positive on the India Rupee on the following grounds:
l Positive growth of the economy
l Continued capital inflows, including into equity markets
l Growing optimism of initial offering by corporates
l Rally in the stock market
l Government's plan in further improving policy fundamentals
l Positive growth in industrial production
l Stable inflation
l Growing Foreign Currency Reserves
We expect the India Rupee to further gain grounds in short term and make a first move to 43.66 levels and should the RBI refrain from any intervention, we see it at 43.35 by October 05, around the time when the RBI announces the busy season credit policy. The oil price moving above USD 55 per barrel may pull down the INR strength.
Domestic Update:
Political uncertainty and complex security situation remains a concern and these reasons have led the Asian Development Bank scaling down the growth rate to 3% for the current fiscal year. Inflation rate is put at 4.5% due to adjustment in petroleum product prices, VAT and decline in agriculture output. Both 91/364 days T/Bill rates are seen climbing up, we expect the same to move upwards as we have been observing NRB issuing fresh T/Bills. The SLF rate is seen trading close to 5% and above. Similarly the interbank rates have also remained close to 5% pa.
Liquidity:
Liquidity has remained a concern since the central bank started charging 2% premium over the 91 days Treasury bill rate on standing liquidity facility offered to commercial banks. Inter bank call market was seen with very low activity as commercial bank were witnessing withdrawals from public sector undertakings account with them. The excess liquidity of the market is absorbed by NRB with the issuance of fresh T/Bills.
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