The dollar goes from strength to strength

When in school, I remember doing a play by Samuel Beckett called Waiting for Godot. The plot centres around two tramps who are waiting by a sickly looking tree for the arrival for a Mr Godot.

As the plot unravels and various characters play their part, it becomes painfully obvious that Godot is not going to come, not today, not tomorrow.

To some extent, the plot of this play reminds me of what has been happening in the foreign exchange markets this year.

We ended the year 2004 on an extremely bearish note for the US dollar. The greenback had fallen to record lows against both the euro (1.3667) and pound (1.9550).

The yen too had rallied to 101.65 against the dollar. It was with this backdrop that we began 2005. Needless to say, there was no reason for anyone to believe that the story this year would be any different.

After all, the burgeoning trade deficit of the US was only likely to grow and there was a perception that the gratuitous inflow of capital from foreign central banks (mainly Asian) to fund this deficit would not last forever.

However, 2005 began on an entirely different note, one of dollar strength. This new theme was not a passing phase but appears to have more or less been a constant throughout the year.

For many of us in the financial markets, waiting for the dollar downtrend of 2004 to resume, appears to have been rather similar to Waiting for Godot, it has not come!

Last week, the dollar rally saw the euro fall below 1.1700, pound below 1.7200 and yen nearly hit 120.

This has truly been a reversal of fortunes and for those of us caught on the wrong foot, we can probably find some solace in the fact that even the best of the best like Warren Buffet have got it wrong betting on dollar weakness.

You may sit wondering what's gone wrong or if you are a dollar bull, what's gone right. The US trade deficit has not disappeared and in fact came in at a record $66 billion for the month of September.

But what is a trade deficit of $66 billion when the net capital inflows into the US for the month of September also hit a record high of $101 billion!

The reality is that players in the foreign exchange markets, are often like children at an ice-cream parlour what is the favourite flavour one week, may not find favour the next.

Thus, while traders and analysts focused endlessly on the US trade deficit and its ramifications in 2004, the flavour or flavours in 2005 have been very different.

The cornerstone of the dollar's rally in 2005 has been rising US interest rates and the impact on interest rate differentials vis-à-vis other currencies.

This not something that has been a bolt from the blue because the Fed began hiking rates in June 2004 and by December 2004 had hiked the Fed Funds rate by 100bps to 2 per cent.

However, what has happened in 2005 is that the Fed has hiked rates all the way to 4 per cent and is likely to continue to do so at least until we hit 4.50 per cent.

Add to this the fact that the Bank of England has actually cut interest rates and while we have had hawkish statements from the European Central Bank (ECB), the words have remained just words.

In December 2004, the 5-year USD swap rate was 85bps below the Sterling swap rate, today it stands 20bps above. Against the euro, the swap spread has increased from 85bps over in December 2004 to nearly 180bps.

And as any economics textbook would have taught you, capital does tend to flow towards the highest returns!

The writer is regional head of sales, HSBC Global Markets, Middle East. Views expressed herein are his own and not necessarily those of his employer.