Deficit fears drive dollar down despite solid economy

...The dollar should be enjoying a hot summer

NEW YORK – Blessed by a resilient US economy that has so far shrugged off the impact of record-high oil prices, the dollar should be enjoying a hot summer.

Instead, analysts say, the greenback has been chilled by a revival of fears for the sustainability of the US economy’s Achilles heel — gaping shortfalls in the current account and trade balance.

From May to July, the US currency benefited against the euro by political crisis across the Atlantic sparked by the refusal of French and Dutch voters to back the European Union’s new constitution.

Their «no» votes in referendums raised question marks over the very future of the EU’s monetary union, exacerbating pressure on the common currency brought on by fears that the 12-nation eurozone was staring at recession.

During the same period, the US economy enjoyed a raft of solid data readings, far outpacing eurozone growth. As a result, by early July, the euro had fallen to about 1.19 dollars from 1.29 two months before.

But since then, the dollar has progressively declined to hit a recent low of 1.2486 for one euro on Friday. Late on Tuesday, it was changing hands at 1.2361 against the euro.

The dollar’s fall has come despite the Federal Reserve continuing on a path of «measured» interest rate hikes that have taken the benchmark US rate to 3.50 percent.

In contrast, the European Central Bank has stuck rigidly to eurozone borrowing costs at 2.0 percent, and shows no signs of relenting to political pressure to reduce rates.

That difference in rates should ordinarily encourage investors to buy dollars to capitalise on the superior rate of return offered on this side of the Atlantic.

«The better economic story and the Fed tightening were the main drivers behind the dollar rally, but that has now run its course,» FX Analytics analyst David Solin said.

Greg Anderson at ABN-Amro bank said the euro has also been helped by an easing of economic concerns with investors having «got overexposed to the dollar».

«At this point Europe is not fighting a recession and there have been no rate cuts,» he said. «Growth is coming OK for the second quarter.»

On the other hand, for the dollar, investors have grown skittish in pondering the potentially debilitating effects of the twin US deficits.

Foreign governments, particularly China’s, have eagerly been buying up US assets such as Treasury bonds to keep the deficits well financed.

But analysts fear that their interest could eventually wane if the dollar stages a deeper decline or if the economy turns down sharply, making US assets less attractive to hold.

«Banks have risks of exposure limits, and they have portfolio targets,» Anderson said, explaining the new-found reluctance to amass an excess of dollars.

«They got to those limits in July,» he said.

Thomas Benfer, currency trader at the Bank of Montreal, said several central banks around the world have started to diversify their foreign exchange reserves to lessen their exposure to the greenback.

«Some people have had to get out, which made the dollar decline,» he said, noting that the euro had been the main beneficiary of this switch in reserves.

Asian currencies have also risen sharply against the dollar after China revalued the yuan at the end of July, following months of intense US pressure.

The yen, shrugging off political uncertainty surrounding a snap general election due on September 11, has benefited from signs that Japan’s economy could finally be on the mend after a slump dating back to the early 1990s.

Solin at FX Analytics predicted the euro could rise as high as 1.25 dollars by the end of August in light summer trading.

But he said that once trading volumes get back to normal, «people will be back asking the reason for this euro rally and will be back buying the dollar».

At the same time, however, the dollar needs «a growth acceleration or more aggressive rate hikes» to stage a convincing rally, Solin added.

The impact of the high oil prices could yet see the US economy turn down, some economists believe.