Since the beginning to the year, the dollar exchange rate gained more than 12%, expressed in euros, contrary to what economists were predicting, basing  their forecast on fears created by the financing needs of the american deficits. For the last few months, the worldwide flows of funds have eluded all forecasts. They remain attracted by the United States, where the monetary rates are the highest. Opinions diverge on the likely future value of the dollar. At present, this future value depends mostly on central banks monetary policies. Central banks play a more and more important role on foreign exchange markets. Compared to investments made by central banks, now, hedge funds are no longer major players. The unified euro currency has curbed their possibility to play one european currency against another. It is within this context that George W. Bush must nominate the person who will replace Alan Greenspan at the head of the american central bank (the Fed).

 

The climb of the dollar rate eludes all forecasts

by CÚcile Prudhomme, Le Monde, October 20th, 2005

Due to the american deficits, most experts thought the dollar would fall. It is the contrary, however, that happened, as a consequence of the higher interest rates offered in the United States. The financial world is destabilised, and is split into different opinions concerning the future.

According to the commonly accepted opinion in the financial community at the beginning of the year, 2005 was to be the fourth year in a row during which the dollar would fall. Yet, 2005 may well be the year of the dollar rebirth. Since the beginning of year, the dollar appreciated by more than 12% in terms of euros. Wednesday October 19th, the exchange rate was 1,1882 dollar for one euro, down from around 1,35 in January. (1,1882/1,35 = 1 - 12%.)

Fears concerning the financing needs of the american deficits (federal budget, and external trade), which were used to justify forecasts of a falling dollar, did not affect the american currency. Economists, who predicted the euro as high as $1,40, after the record deficits of 2004, turned out to be wrong.

But, for the last few months, worldwide fund flows elude all prediction. They remain attracted by the United States, where the monetary rates, at present, are the highest, whatever the maturity. American short term bills pay 3,75%, compared to 2% in Europe, and just about zero in Japan. Ten year bonds pay 4,49% in the US, compared to 3,30% in Europe, and 1,50% in Japan. And, in spite of two hurricanes, growth perspectives remain higher in the United States than in the other important monetary zones.

Since the situation is not expected to change soon, economists have revised their forecasts. Many of them, now, see the dollar staying on an ascending trajectory. But doubts linger, in their mind, concerning the financing of the US deficits. According to a poll carried out by Bloomberg among 53 market operators, financial strategists, and investors, 60% of them said they were buying dollars. It is the highest proportion since last June.

But financial community forecasts are not homogeneous. Axa Investment Managers strategists foresee the dollar keeping climbing, and reaching the rate $1,15 to the euro within six to twelve months. On the other hand, UBS strategists maintain their view that the dollar will fall because they think the US trade deficit cannot go on. They foresee the euro, in three months, back to $1,24, not far from the $1,25 forecast by canadian bank CBC, or $1,23 predicted by HSBC CCF.

"The right scapegoat"

During a round table organised in Paris, October 4th, by the Chicago Mercantile Exchange (the Chicago market for futures), Evariste Lefeuvre, deputy manager of the research service at Ixis CIB, summarised the difficulty for economists to make forecasts : "Our problem, in order to make forecasts on the dollar and the euro, is to find the right scapegoat at the right time, he explains. A few months ago, explanations with the variation of the american trade deficit worked well, today it seems that the difference in interest rates between the US and Europe is the main explanatory factor."

It is hard to find one's bearings, concedes Patrick Artus, chief manager of the research service at Ixis CIB, who, in a working paper of October 11th, notes that "the equilibrium between two groups of factors [on the one hand the worrisome economic situation in Europe, and on the other hand the weakening of the US economy due to climbing oil prices and the deterioration of their current balance] is difficult to measure, which, as a consequence, causes a rather erratic euro/dollar short term parity, without any clear trend."

The main force sustaining the dollar is the difference in short term rates on both sides of the Atlantic ; and this difference should increase between now and the end of 2005, as economists did anticipate at the beginning of the year. The climb of US rates, set by the Fed, should continue, while the European Central Bank (ECB) will keep its wait and see position and will not change its rates.

Bloomberg poll of last September showed that forecasters expected the Fed's short term rate to reach 4,5% at the end of 2005. David Rosenberg, chief economist at Merrill Lynch, who foresees a maximum of 4,5% for federal borrowings, thinks that the climb will keep on in 2006. Strategists at HSBC CCF see it climb to 5% in September 2006.

At the ECB, opinions differ as to when the European Central Bank will raise its rate : first semester 2006, say some ; second semester, say some others ; nothing in 2006, still others say.

Market rates give a 70% probability to the scenario of a rate climb between now and March 2006. It will all depend upon inflation. Jean-Claude Trichet, president of the ECB, stressed this point in a letter, sent last Tuesday, October 18th, to the European parliament : the ECB "will act decisively if the climb in oil prices were to create price increases in other sectors of the economy, causing secondary effects and/or bigger anticipated inflation", did he explain. A Damocles sword, which the ECB, who detests nothing more than back track on its opinions, will let fall only when it is sure of the effect of its decision.

CÚcile Prudhomme