Oil prices not the only fuel for dollar decline

THE summer lull in foreign exchange markets came to an abrupt end last week, when the euro rallied to a three-month high against the dollar.

Late last week the euro bought more than $1.25 for the first time since late May for the first time since the market over-reacted to the defeat of the proposed European constitution in both France and Holland.

So what caused this rally in the single currency?

In no particular order, blame hurricane Katrina, oil prices, global growth concerns, the possibility of a pause in the US interest rate tightening cycle and hawkish comments from the European Central Bank.

Let's start our analysis by looking at growth concerns. Rising oil prices had, up until now, generally been interpreted as a sign of strong global growth and therefore a good thing.

The break of the $70 level, and the realisation that energy costs will likely rise higher if hurricane Katrina has damaged America's refining capacity, has changed how the market looks at oil: a rising price is no longer seen as indicative of strong global growth suddenly it's a threat to global growth.

Given America's dependency on oil (consumption of crude in Western Europe has fallen over the past 25 years whereas it has risen in the US), the rising cost of crude is now being seen as dollar negative.

Other growth concerns came to the fore late last week when the US Institute of Supply Management released its August survey of US manufacturing activity against expectations, respondents reported decreased manufacturing output in August, before the hurricane struck, and before oil prices spiked to the $70 level.

If America's output was slowing before the hurricane and the record oil price, it's hardly likely to rebound in September.

Finally, the market is now starting to ask just what impact the ongoing events in Louisiana will have on the Federal Reserve's rate tightening cycle. Consumer prices are still rising in the US, but unlike the European Central Bank, America's central bank doesn't have an explicit inflation target.

The Fed can leave rates on hold even if inflation accelerates, unlike its counterpart on this side of the Atlantic.

This is of crucial importance to the outlook for the dollar, since the widening transatlantic interest rate differential in the first half of the year drove much of the dollar's recent gains.

For the Americans it's all about growth, and when it was announced on Thursday that Fed Chairman Alan Greenspan was attending an unscheduled lunch at the White House, rumours started to circulate that President Bush would press for the Fed to now abandon its plans to hike US interest rates further, to ease the recovery of America's gulf coast.

In fairness, it's unlikely that Greenspan would bow to direct political pressure, but if the hurricane is the straw that breaks the camel's back (if growth does suffer in the US as a result of the storm), then the Fed might well pause, to the dollar's detriment.

That's why we hold with our call for a $1.30 euro/dollar exchange rate by year-end.

The views and opinions expressed in this article are those of the author and do not necessarily correspond with those of Ulster Bank or any other member of the RBS Group.

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