The clear hint from Jean-Claude Trichet, president of the European Central Bank, that eurozone interest rates would shortly rise seems to have put a halt to the dollar’s march forward against the euro. The European currency reached a two-week high against the greenback on Monday.
The dollar’s yield appeal (US short rates are now 2 percentage points higher than eurozone rates) are widely assumed to have been the driving force behind the dollar’s strength this year. But one analyst, David Woo of Barclays Capital, disagrees with this thesis.
Woo believes that the dollar has been rallying “under false pretences”. He thinks it has been highly significant that the dollar has rallied strongly twice in recent weeks on what looked like negative economic news: first, the weak non-farm payrolls and then a wider-than-expected trade deficit.
Both would normally have been expected to cause the dollar to weaken.
If the dollar is moving in the “wrong” direction, that suggests to Woo that some party is looking to buy the currency on any sign of weakness. That party is the US corporate sector, bringing money home under the terms of the Homeland Investment Act. The Act reduced the tax rate for US multinationals repatriating their overseas earnings, but the break only lasts for one year.
Woo says that third-quarter earnings reports suggested that substantial flows would be repatriated in the fourth quarter, before the tax break ends. That would involve US companies selling overseas currencies and buying the dollar and thus would be positive for the US currency.
However, Woo points out that these flows will disappear in 2006, which should weigh on the dollar’s prospects.
How much will the dollar be affected?
Woo says that a $10bn negative surprise in the US current account deficit has historically led to a 1 per cent fall in the dollar against the euro. Repatriation flows under the Homeland Investment Act are estimated at $50bn-$100bn, which suggests the dollar could fall by 5-10 per cent against the euro.
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