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Majority say euro is set to decline against dollar Back  
Euro will decline against dollar but will remain strong.
Niall Dunne
Market sentiment toward the dollar has changed significantly over the last quarter. In January, with EUR/USD approaching 1.2800 and EUR/GBP trading at 0.6750, the euro looked set to strengthen further in the year ahead. However, improving US labour market indicators throughout the first quarter and rising American inflation have led some analysts to declare that the dollar’s decline is now over.

We in Ulster Bank Financial Markets don’t share this view, because in our opinion, the dollar might yet have to weaken further to materially reduce the deficit on America’s current account. We also believe that the US is approaching other obstacles on the road to sustainable economic recovery, which may prove impassable without the artificial stimulus of a weak dollar.

We believe that economic fundamentals will soon see EUR/USD strengthen. Consider America’s budget deficit. Over the course of 2003, America amassed a budget deficit in excess of USD$500 million. Naturally, to spend money it didn’t have, America had to borrow, which it did extensively through the government bond market. However, with the prospect of a higher base interest rate now a reality, the budget deficit could become particularly problematic and costly in the year ahead.

America simply cannot afford to indefinitely run excessive budget deficits, because debt costs are rising and creditors’ willingness to lend is waning. Japan’s apparent abandonment of foreign exchange intervention could result in declining capital flows into the US. Irrespective of who wins the election, we take the view that America will have to cut back on its spending as we move into 2005.

We are also of the opinion that America will have to raise its taxes after the election, or at the very least reverse the tax cuts made by the Republicans during this administration. It simply is untenable for a country to continuously increase its spending while simultaneously reducing tax receipts, and there is a risk that higher taxes will take a toll on consumer consumption, which sustained the American economy throughout the downturn.

It’s also important to remember that against a backdrop of rising taxes and spending cutbacks, US interest rates will also be gradually rising in the year ahead. Companies will have to cope with higher borrowing costs as inflationary pressures necessitate higher interest rates, and as a result, corporate America will continue to seek ways to cut costs.

So to insure against a double-dip downturn, America needs the dollar to remain weak. The market knows that the US will soon have to cope without fiscal and monetary stimuli, so it’s unlikely that the above trend growth seen in 2003 will last across 2004 and 2005. The market also knows that government spending will soon be cut back, and fears that taxes will have to rise. What cumulative effect this will have on consumer demand, the backbone of the American economy, is open for debate. However, it’s easy to see why America will not want the additional strain of an appreciating dollar, as we move further into 2004.

The recent strength of sterling can be attributed to rising UK interest rates. The Bank of England’s Monetary Policy Committee (MPC) is actively raising the British base interest rate because of the pace of economic activity in the UK - specifically the pace of activity in the property market.

When the MPC increased the British repo rise on February 5th, it was widely viewed as a pre-emptive move, one which the MPC hoped would force consumers to reassess their ability to repay debt. And it seemed to work, because consumer confidence fell shortly after the hike, as consumers responded that they would have less disposable income to spend as a result of higher mortgage repayments. By late February the market concluded that the rate hike had worked, assumed that further rate rises would be postponed, and allowed EUR/GBP to drift back toward 0.7000 (GBP/EUR 1.4300). However, the MPC’s warning shot was soon forgotten.

Recently released mortgage borrowing figures soon dispelled any thoughts of a correction in UK property prices. This re-ignited market expectations of further UK interest rate rises, and forced EUR/GBP to the 0.6600 range, where it trades as we go to print.

Yet the MPC did not raise interest rates at their last meeting on April 8th. We believe that the strength of the pound was the decisive factor in the MPC’s April interest rate decision, when the British base rate was left on hold at 4 per cent. Had the MPC voted for a rate rise, EUR/GBP might well have fallen sharply below 0.6500, to the detriment of UK exporters competing in Britain’s largest export market - the Eurozone. By holding rates steady in April, despite consumer debt rising to a record level, we feel that the MPC signalled that they do not want the pound to rise further.

The current weakness of EUR/GBP can easily be explained in terms of anaemic Eurozone growth relative to the UK, and concerns over the rigidity of Eurozone fiscal and monetary policy relative to the UK. Yet there is one thing that both the UK and the Eurozone now share - an over-valued currency, relative to primary external trading partners.

Remember that Britain’s economic fortunes are closely linked to its nearest and most important neighbour - the Eurozone. The UK is too dependent on exports to Europe for sterling to indefinitely benefit from Eurozone weakness and expectations of higher UK rates. That’s why we expect EUR/GBP to rise gradually over the course of the year. That’s why we believe that corporates with GBP receivables might want to consider possible hedging strategies now, because we believe that the pound is set to fall against the single currency.

Noel Griffin
The main issue in the Forex markets over the past year or so has been dollar weakness. While the dollar is likely to remain quite volatile for some months I believe the currencies decline against both the euro and sterling is unlikely to continue. As the US economic recovery gathers momentum this will lead to higher US interest rates throughout 2004 and 2005. This in turn will lead to a stronger dollar.

In the case of euro/sterling the increasing interest rate environment coupled with an improving economy in the eurozone will support a stronger euro.

In the case of euro/yen I expect some yen strength based on a stronger Japanese economy and the decision by the Bank of Japan to abandon its policy of intervening to weaken the yen.

Oliver Mangan
While forex markets may remain volatile, they could trade in much narrower ranges in the period ahead than has typified recent years. Key exchange rates now seem much closer to their long run equilibrium values than in the recent past.

The dollar has moved on to a somewhat more firmer footing, pushed along by heightened market expectations about the US economy. Though market conditions will remain volatile, the dollar should have more upside potential, particularly if upcoming data are supportive.
However, in light of the dollar’s more fundamental problems and the possibility that the growth in the US economy could peak around mid-year, we are reluctant to call the euro much below the $1.15 level on any sustained basis over the balance of 2004.

As we envisage that the dollar could retain its recent momentum in the near term, there is scope for cable to fall further within a $1.75-$1.80 range over the next three months. However, some softening of the dollar towards the end of the year could push cable back up to a $1.80-$1.85 range, with dollar-euro moving back to $1.20.

Factors such as the weaker euro area economy relative to the much healthier UK economy and the positive interest rate gap in sterling’s favour should see the sterling-euro rate trade within ?0.65-0.67 over the next three months and possibly move higher to ?0.64-0.66 on a 3-6 month view.

It is envisaged that the recovery in the Japanese economy will provide scope for the yen to appreciate somewhat further, making modest gains against both the dollar and the euro later this year.

Dan McLoughlin
It is often the case that markets turn just at the point public sentiiment is at its most extreme, The euro bottomed at 82cents in 2001, for example, when bearish comment was at its height. Similarly, the euro topped out in January, coinciding with a stream of forecasts calling for further strong gains to $1.50 and above. The euro’s gains were partly a reflection of strong bond inflows and partly by default , as the market found it easier to sell dollars against the euro than against the Asian currencies. Similarly the single currencies recent fall can be attributed to renewed capital outflows and the expectation of higher US interest rates, which has underpinned the greenback. Consequently I expect the euro to trade in a $1.10 to $1.20 range against the dollar over the coming year with the cyclical positives for the US currency outweighing the structural negatives relating to the trade deficit. For sterling, the key development has been the formal rejection by the UK Treasury of euro membership, which now looks some years off at least. Nevertheless I would expect to see sterling trade in a relatively narrow range against the euro, 65-71 pence, with a bias to the lower figure given the superior performance of the UK economy and the large interest rate differential in its favour.

Alan McQuaid
The major currency markets appear to be stabilising after a tumultuous 18-month US dollar bear market. The euro has peaked and will likely slip back toward 1.10 against the dollar over the next 6-12 months. Conversely, the yen will rally steadily on the back of the Japanese economic recovery. The commodity currencies are proving resilient, but could soften in the short-term if commodity prices undergo a long overdue correction. The softening of the Eurozone economy in recent months has been the catalyst for the pullback of the euro against the dollar since mid-January. The comparative strength of the US economy should put downward pressure on the euro, especially with the possibility of an ECB rate cut in the near future. The euro is also likely to weaken against sterling in the coming months, but sterling itself should weaken against the dollar. The yen will likely be the big play in currency markets in the short-term. Japanese officials have backed away from earlier commitments to sustain intervention, in effect giving speculators a free pass to buy the yen. Ultimately, Japanese authorities will intervene if necessary to manage the rise in the yen, but they appear increasingly confident that the economy can sustain a stronger currency. On a real-trade weighted basis, the yen is still near the bottom of its longer-term range, indicating it has considerable upside potential. Prospects for a renminbi revaluation this year are fading as the Chinese trade account has moved into deficit. The renminbi is undervalued, but the Chinese authorities appear increasingly reluctant to permit it to appreciate when the country’s trade account is deteriorating, even though export growth remains robust. Inflation has to pick up more decisively and the trade balance has to return to a surplus to put a possible revaluation back on the table this year.

Brendan Seaver
We expect the EUR/USD overshoot to stabilise in the first half of the current year and gradually reverse in the second half and throughout 2005. Cyclical economic factors, currency policy developments, and valuation dynamics broadly support this projection. A temporary return to a 1.30 (and above) is a low probability event at this stage, although it cannot be totally ruled out as trends in relative demand continue to favour the US economy, thereby keeping the US current account deficit under pressure. At the same time, several factors including relative growth uncertainty, geopolitical risks, US elections and slow reversion of market sentiment will cushion the EUR/USD downside to some extent. Since the beginning of 2004, we have seen some de-coupling between the EUR and GBP performance vs. the USD. We expect the GBP to stay relatively strong against the EUR in the near term. The BoE has entered the hiking cycle much earlier than the other major economies and the rate advantage of the UK is likely to diminish over time. The overheating in the consumer and housing sectors poses significant risks to the UK growth profile going forward and this will come into play gradually in the medium term. The expected appreciation of the USD against all major currencies will result in a modest depreciation of the JPY vs. the EUR over the forecast horizon.

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