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The Bull Case for the Dollar

Forget the GDP and focus on the dollar-positive factors: the Fed, upcoming data and technicals.

This column was originally published on RealMoney on Jan. 27 at 4:00 p.m. EST. It's being republished as a bonus for readers.

The disappointing fourth-quarter U.S. gross domestic product report and subsequent decline in the dollar are unlikely to have a lasting impact on the market. In fact, there are good reasons to expect the U.S. dollar to strengthen in the days ahead.

The 1.1% pace of growth in the last quarter of 2005 was the slowest since the first quarter of 2003, and it breaks the string of 10 consecutive quarters of 3%-plus growth. Nevertheless, early indications suggest the U.S. economy has rebounded. When considering the outlook for the

Federal Reserve

and the dollar, keep in mind that this factor is more important than the fourth-quarter disappointment.

Three Dollar-Positive Developments

There will be three major economic developments next week in the U.S., and I believe that each will be dollar-friendly.

First, on Tuesday I expect the Federal Reserve will hike the fed funds target by 25 basis points to 4.5%. As is well appreciated, Fed officials use the news media to signal the market, i.e., help guide expectations. A couple such Fed-watchers have opined recently that the statement that accompanies the rate decision is likely to keep the door open to further rate hikes. That's consistent with my view that while the Fed's work is nearly done, there are a few more hikes likely. I believe the funds rate will peak at 5.0%-5.25%.

Market participants appear to have upgraded their assessment of the risk of a March hike. As recently as Jan. 17 and 18, the market was roughly evenly divided between those expecting a March hike and those taking the "one-and-done" stance. However, more recently the pendulum of market sentiment has swung toward the March hike. The odds rose from a little more than 50% to more than 75% and retreated to about 66% after the disappointing GDP data. If next week's data are as strong as the consensus currently expects, the market is likely to upgrade the odds of a March hike.

Second, although it might have been lost in the preliminary quarterly data, momentum in the U.S. economy probably improved at the end of 2005. Recall that the ISM Index: Manufacturing data were revised, showing a larger gain in December (55.6 from 54.2), while the October and November data were revised lower. The strength of the Philly and Richmond Fed surveys and the Empire State survey suggest the January manufacturing ISM should be firm. That would confirm continued strength in the manufacturing sector, which appears to be picking up some slack from the slowing of the housing market. This also touches on the issue raised by the Fed last month about resource utilization rates.

Third, the U.S. will report January jobs data on Friday, Feb. 3. The preliminary estimate is for a robust 240,000, following the disappointing 108,000 increase in December. Although the fit is imperfect, to be sure, the weekly initial jobless claims stand near their lowest level in five years, suggesting some improvement in the labor market. If, and admittedly this is a big "if," this turns out to be a fairly accurate forecast, the three-month average would move above 200,000 to sit at its best level since last April. Such a strong report also would be dollar-friendly and would reinforce ideas that economic growth is sufficiently robust to continue to absorb whatever slack remains in the economy. It also would seem to underscore the likelihood of additional Fed tightening.

Spreading Good Cheer

In addition to the data pipeline, another dollar-positive development has been interest rate differentials. The spread between the June Euribor and the June Eurodollar futures contract has gradually widened in recent days and has resurfaced above 200 basis points. On Jan. 3, the spread stood near 188 basis points. Of course, a 12 basis point shift is nothing to get excited about, but the direction is what matters here, and it's dollar-positive. Also, it's still not clear that the short-term interest rate differentials have peaked in the cycle. The high of the spread thus far was set in mid-August 2005, near 220 basis points.

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The 10-year spread between the U.S. Treasuries and German bunds (a useful proxy for the euro zone) also has widened in recent sessions. The spread put in a recent high last October, near 123 bp, after finishing 2004 near 55 basis points. However, the spread narrowed to about 95 basis points in late November. As recently as Monday, Jan. 23, the spread stood at 97.4 and is now back above 102 basis points. Again, the magnitude of the move is more important than the actual amount of the spread.

Technical Advantages

There also are a number of technical indications that the dollar may come back into favor after beginning the year heavily. Looking at the euro, it is interesting to note that the magnitude of the bounce off the late November 2005 lows has been very much in line with the size of euro corrections seen during last year's dollar bull run.

In addition, the

MACD (moving average convergence/divergence) is crossing to the downside for the euro from its highest level since last August. Just as important is the fact that the euro had moved above its 200-day moving average on Jan. 23 for the first time since last spring, and although it spent a few days above there, it was rebuffed, despite the soft U.S. GDP data. The euro spent most of the past month in the $1.2000-$1.2200 trading range. The breakout to the upside proved premature. Now we should anticipate a test on the lower end of that old range.

The technical picture of the Swiss franc and sterling confirms this bullish outlook for the U.S. dollar. Sterling moved through its 200-day moving average on Jan. 25, but never managed to close above it. It has since moved lower. It has near-term potential toward $1.74-$1.75 in the days ahead. The dollar had fallen through its 200-day moving average against the Swiss franc, and has snapped back above it during this session. Initially, the dollar can rise toward CHF1.29-CHF1.30.

The yen is marching to the beat of its own drummer, but the dollar is likely to continue to recover against it. The dollar never fell through its 200-day moving average against the yen, which comes in near JPY112.70 now. This suggests that the dramatic slide that started in December 2005 weakened, but did not break, the dollar bulls. Indeed, the dollar has already retraced 38.2% of that decline and appears headed toward JPY117.50 to JPY118.30 in the period ahead.

On the face of it, Japanese fundamentals appear solid. Economic data generally have confirmed a broadening of the recovery in that nation, and inflation data suggest that deflationary forces there are weakening. Foreign flows into the Japanese equity market were not deterred by the recent slide, from which the Nikkei has fully recovered.

The source of the yen's weakness appears to be the recognition that Japanese officials will only gradually move away from the government's extraordinarily accommodative monetary policy. Even the hawks at the Bank of Japan who consistently have been over-voted are only seeking a minor reduction in the liquidity the BOJ continues to provide.

Another implication of this analysis is that the currencies of the emerging markets, especially in Latin America and East Asia, look favorable. In Latin America, flows into the bond and stock markets coupled with improved macro-fundamentals suggest that both the Brazilian real and Mexican peso can appreciate further. In East Asia, foreign investors continue to pour money into the local equity markets, and the regional currencies are generally experiencing upside pressure that central banks may lean against but will not be able to completely deter.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;

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