Heightened levels of interest in foreign exchange

AT THE time of writing, the US Dollar (USD) is looking less like the flavour of the month and more like yesterday’s leftovers. International investors have maintained the strength of the USD for the last year – lured by ever higher interest rate returns, with the Federal Reserve raising the base interest rate from 1.0 per cent to 4.5 per cent in 14 straight moves.

The positive shine the Fed’s determined efforts put on the Dollar maintained the inward flow of international money searching for higher interest rate yields, and there appeared to be no let up in the gains that they could expect. However, the last month has changed all that. While traders were convinced that the US base rate would reach 5.25 per cent and possibly 5.5 per cent before the end of 2006, they are less convinced today and more likely to believe that we are very near the end of that interest rate hiking cycle.

The recent stream of bad US news chimes like a death knell for the Dollar: falling high street sales, sliding manufacturing optimism, a beige book report saying that inflationary pressures are scant, falling housing starts, rising unemployment claims, inflation at 2.1 per cent, record current account and budget deficits and insufficient inward investment to balance the books!

When looked at in this way, it is a wonder that anyone would think of buying the US currency ever again. However, despite the fall in the value of the USD that accompanied these data releases, there are buyers keeping the USD below http://www..76 against the Pound and http://www..22 against the Euro. What do they see in the currency?

Well, it is the most liquid and widely accepted currency in the world … The US economy is still outgrowing the EU and UK in percentage terms, and the US interest rate is set to rise above the 4.5 per cent of the UK offers, plus it is well above the 2.5 per cent available in the Eurozone. And even if the Bank of Japan does start to raise their base rate – and I don’t think that will happen this year – it will take a long time before they can even come close to the US yield. So it really isn’t the US Dollar in isolation that represents an attractive bet, it is the comparison of the USD with the alternatives.

In the short term, I still think http://www..7620 against the Pound and http://www..2220 on the Euro are very strong resistance levels and should hold. If they do, the downward trend in these currency pairs is still intact and we are envisaging an early fall to http://www..7040 and http://www..1820 respectively. We are also quite convinced that the GBPUSD rate will fall as far as http://www..66 before the end of 2006, but the Euro-Dollar exchange rate has less downside potential. The European Central Bank has made great play of their plans to raise the Eurozone base rate if they foresee any pick up in inflation. There are certainly plenty of signs that they should be very vigilant and plenty of traders who expect the Eurozone base interest rate to reach 3.5 per cent before the ECB can relax their vigilance.

This should keep the pressure on the USD and should keep the Euro-Dollar rate above http://www..17 for a while to come. This EU interest rate story is also pressing the GBPEUR exchange rate down to ¤1.4320 and even below ¤1.40 in the coming months. The recent push below ¤1.45 was highly significant because it broke an upward trend that started in 1996 (based on a synthetic exchange rate calculated from the GBP-Deutschemark exchange rate). The fall in this currency paid could even reach as low as ¤1.36.

In essence, the changes that will take place in the market this year have the potential to make 2006 one of the most volatile years on record. Within this melee, the chance to exchange your funds at the right time will present themselves. I would urge you to speak with a currency specialist to ensure you are made aware of just when that opportunity arises.

Contributed by David Johnson

Commercial foreign exchange dealer

Halo Financial Ltd