We are encouraged as to the outlook for the dollar following the Federal Reserve's controversial 25-basis point ease of June 25. The Federal Open Market Committee statement supported our own assessment that the U.S. economy is on a reasonably positive course, though still lacking impetus of the kind which would bolster confidence as to a significantly stronger second half. Market sentiment has shifted cautiously to the logic of growth, favoring more dollar gains.

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Particularly heartening in this respect was euro-dollar's move last week under US$1.15. This sets up a further decline towards the US$1.10 level which we consider to represent fair or medium-term equilibrium value. Such a move depends on two closely related factors: economic activity reports and stock prices. Investors want to see clearer indications of a second-half acceleration in sales and earnings and could be discouraged at times by ambiguous data, including still-unsatisfactory business investment, and Q2 earnings disappointments.

Financial markets must work through the implications of the Fed ease, in particular the balance between guarded optimism and understated concern as to deflation risks. Many in the U.S. Treasury market expressed disappointment and even a sense of betrayal that the Fed did not ease by the 50 basis points discounted by a bulled-up bond market. Their complaint is that Fed officials led the bond market down the garden path with the comments intimating concern about deflation. But it should have been clear that the case for a 25 bp ease was reasonable.

Potential for Bond Market Selloff

The next question for bonds is whether the Fed will have to ease again. With funds at levels not seen since 1958 and longer-term rates also very low historically, it is hard to make the case that monetary conditions are not stimulative enough. What is needed is a pickup in business investment and some convincing evidence that the job market has stabilized if not turned around, starting with a sustained move under the 400,000 level in state-level unemployment claims followed by modest gains in the monthly U.S. nonfarm jobs data.

The 22,000 drop in initial claims in the week ended June 21 was a good start, though it left the national total at 404,000, over the key 400,000 level for the 19th straight week. Forecasts from market analysts for June U.S. jobs range from little change to a 50,000 nonfarm jobs loss. A significantly stronger outcome could unnerve bonds, inspiring longer-term profit-taking and asset reallocation.

In other words, where the Fed stands on rates could be the least of the Treasury market's problems.

Such a development could help the dollar by reinforcing the flow of funds out of global fixed-income investments and into U.S. equities, and by driving U.S. government and corporate yields to more competitive levels. With a dollar recovery in prospect, global investors would also be enticed by potential currency gains that would, moreover, by far outweigh the attraction of a 100 basis point pickup in the euro.

Euro Case Deteriorating

In any case, that yield advantage stands to be further diminished before long. The example of the Fed has increased pressure on the European Central Bank to follow up its recent 50 bp ease with a further quarter point of accommodation, and perhaps by another 25 bp after that by September. One should not underestimate the capacity of ECB President Wim Duisenberg for dithering, though. He told a German television journalist last week that low confidence amongst consumers and business is responsible for the collapse in European activity, not the level of interest rates. Perhaps a crash course with Mr. Greenspan on the central bank economic signaling function might help.

Maybe not. Duisenberg further laid blame for Germany's economic plight on the countries fiscal policies, which he implied have undermined "people's confidence in their future." He insisted on the primacy of keeping "promises that have been made," alluding to the EU Growth and Stability Pact, which Germany of late has been honoring more in the breach than in the observance - intelligently so.

These statements came soon after German Finance Minister Hans Eichel announced that the country's 2004 deficit would increase to 23.8 billion euros, nearly double previous estimates. The government is also looking at the possibility of advancing by one year personal income tax cuts scheduled for 2005, adding to deficits likely to exceed the Stability Pact's 3-percent-of-GDP limit this year as in 2002.

We are all in favor of "sticking to the rules," as Duisenberg put it. But when the rules are untested and turn out not to make good policy, then they should be stretched if doing so enhances the likelihood of economic recovery, particularly if monetary policy doesn't seem to be getting the job done. Returning to the euro, such European policy disagreement and disarray could further handicap the single currency.

Yen Back to Optimal Levels

While euro-dollar has been the focus of interest, it may be more important to global recovery that dollar-yen recovers levels consistent with stable to slightly positive Japanese output. On the back of the dollar's rally against the euro the dollar pushed over Y119 and should be able to get a foothold on Y120 providing euro-dollar remains under US$1.15. Dollar-yen levels remain politically sensitive, therefore we would expect the U.S. Treasury to make noises should the yen depreciate much beyond Y120. Under such a scenario, Japanese market interest could shift to euro-yen, however with dollar-yen constrained, profit-taking and arbitrage could feed into dollar gains against the euro.

Japanese data have been mildly encouraging, if mixed. Industrial production rose 2.5 percent month on month in May and was expected to rise another 1.2 percent in June, based on Ministry of Finance company surveys. But the MoF said it looked for a 0.7 percent contraction in July. Core consumer inflation in Tokyo fell 0.4 percent year-over-year in June, which confirmed deflation remains entrenched in the economy. May unemployment was steady at 5.4 percent. Nevertheless, SalomonSmithBarney concludes that the Japanese economy is "faltering."

So fundamentals suggest no large moves in dollar-yen. But given official and market barriers to gains over Y120 (Japanese corporates reportedly are eager to sell the dollar forward around Y120 given persistent expectations of lower dollar levels later this year) readers might consider hedging some H2 yen requirements. Flagging USD momentum could inspire a quick return to the 115.50-Y118.50 range.

Relative Stability in Emerging FX

One encouraging development over the past quarter has been the moderate consolidation in emerging market currencies following their steep rise earlier this year, which has most importantly allowed the Mexican peso to find a more sustainable MXN10.45/75 range. This positions the MXN to appreciate or depreciate modestly subject to U.S. fundamentals and sentiment which are both likely to fluctuate for some time.

Also, Mexican authorities are also better equipped to (tacitly) manage the currency through the instrument of dollar reserve sales, enhancing the Bank of Mexico's capabilities in terms of assuring that short-term rates remain at their historical lows.

The Brazilian real has recovered from what was little more than a blip in its case and continues to attract funds. This is not surprising in view of the generally bullish outlook on Brazil under President Luiz Inacio Lula da Silva and with official rates at 26 percent (net of last week's half-point ease). Declining interest rates balanced by fiscal discipline make for a very attractive investment environment. While the Central Bank has lowered the bar in raising its CPI targets for 2004 and 2005, real interest rates around 14 percent should allay such fears.

But the BRL could still be subject to periodic corrections, especially with many players in the emerging debt market growing apprehensive that the 2003 rally has run its course, so from current levels around BRL2.89 to the dollar the real could easily retrace to the BRL3.0 area on a gust of negative market or political sentiment. But the government has built up a large stock of goodwill through its market friendly policies as well as results like the primary budget surplus equal to 4.4 percent of GDP compared with a 4.25 percent target agreed with the IMF.

The South African rand is in a somewhat analogous position, benefiting from high official rates, a strong local-currency bond market and an administration that has earned the respect of the global financial community. That said, the ZAR looks more vulnerable than the BRL to short-term flows, both those actuated by international players and a trade sector that is very sensitive to nuances and quick to hedge exposures on either side of dollar-rand or euro-rand. Hence we would set tight ZAR sell stops should the latest bull run take the currency through ZAR7.60 per dollar; medium-term, a more significant pullback in emerging market bonds could send it back over ZAR8.0.


    - Brendan Murphy, CEO, FXotica.com Inc.