2005 Second Half FX Outlook - Forex Market

Friday, 24 June 2005 GMT - Written by Kathy Lien, Chief Strategist, and Sam Shenker, Technical Currency Analyst


The first half of 2005 has certainly been exciting with a lot of volatile price action in many of the currency pairs. As a result of a significant amount of request from our readers, we have updated our 2005 FX outlook for the EURUSD, USDJPY, GBPUSD, USDCHF, AUDUSD, USDCAD and the NZDUSD. With many events unfolding in the second half of the year, make sure you are prepared to take advantage of these developments.

EURUSD Outlook

Although the euro reached record highs at the beginning of this year, the rally in the currency was not driven by positive European economic news. Instead, the rise in the unit was primarily fueled by massive bearish sentiment towards the dollar. However, now the tables have turned and the bearish sentiment in the EURUSD is being primarily driven by pessimistic sentiment towards Europe. The continent’s economic woes have spilled over into the political arena following the rejection of the new EU Constitution. With the euro being an easy scapegoat for the inability of European politicians to spur growth in their own countries, Italy has led the pack in calling for the dissolution of the euro altogether. This speculation has been the catalyst for the euro’s extensive sell-off through the first half of the year. In fact, what has been happening is that the fundamental landscape for the EURUSD has changed completely. The currency pair used to shrug off any bad euro news, and reacted only based upon US developments, earning itself the title the “anti-dollar.” Now, the currency pair reacts almost solely on euro news and shrugs off bad US data.

Fed’s Rate Hikes Are Holding The Dollar Up

Part of the reason why EUR/USD has been able to ignore US data is because the US continues to aggressively raise interest rates, keeping the dollar bid. This is very important because the Federal Reserve is the only central bank to be aggressively raising rates this year. As a result, traders are buying back dollars to either reverse old carry trades (when they sold dollars as rates were being slashed to 1.00%) or to initiate new ones. In fact, this could even explain some of the confusion with long-term interest rates. The Fed is expected to bring rates back up to at least 3.50%, which means that there may be some more carry trade premium left in the dollar. However once the Fed is done tightening, we may finally get back to fundamentals, at which time, the sole pillar propping up the dollar could topple.

But Fundamentals In The US Are Deteriorating

Across the Atlantic, although the economies of the countries within the Eurozone still remain very weak, especially with Italy sliding back into recession, the 1600 pip slide in the EURUSD appears to be having some stimulative effect on the region’s health. Eurozone industrial orders and the German ZEW survey are but only 2 economic indicators that have surprised on the upside. The US on the other hand has come out with a barrage of disappointing releases; In May of 2005, non-farm payrolls failed to reach 50% of expectations, consumer spending took a sharp dive, inflation pressures were very muted, the manufacturing sector showed signs of significant weakness with the Philadelphia Fed Survey plunging into negative territory, and the current account deficit ballooned to a new record high. Foreign purchases of dollar denominated assets also failed to meet the funding needs of the trade deficit for 2 consecutive months. Globally oil prices have shot to another record that will certainly hurt growth and consumer spending across the globe. The changing trend of economic data should be beneficial for the euro, yet with political factors and the Fed’s aggressive rate hike campaign, the EURUSD could remain under pressure for a few more months.

Greenspan’s Departure Could Be Positive For EURUSD

The end of the Fed's tightening cycle should coincide perfectly with increasing speculation of a replacement for Federal Reserve Chairman Alan Greenspan. After having served under four different Presidents of both Republican and Democratic Administrations, the Fed Chairman is expected to leave office at the end of January, 2006. As one of the most respected central bankers of our time, Greenspan has managed to navigate the nation through the 1987 Stock Market crash, the 1991 oil spike sparked by the Gulf War, the collapse of Long Term Capital Management in 1998, the burst of the NASDAQ bubble, and 9/11, with only minimal setbacks for the economy. During his tenure as Chairman, US GDP increased in 16 out of 17 years - one of the smoothest periods of economic growth in US history. Therefore it will be very difficult to a find a replacement for the world's most effective and esteemed central banker. Right now, there has been minimal speculation for a replacement, but come late summer, early fall, talk of possible successors should be in full swing. With no successor-possibility having as much respect as Greenspan has had with the financial markets, speculation about who his replacement will be will only cause more uncertainty for the US dollar. This timing will coincide perfectly with the end of the Fed tightening cycle.

Reserve Diversification Talk Subsides To A Whisper

Previous euro support from talk of reserve diversification has fallen to the sidelines as many countries wait to see how the EU developments pan out and if the euro is really here to stay. If you recall, last year, several central banks including the Bank of Russia as well as the central banks of various Middle Eastern governments began diversifying their reserve assets from dollars to euros, spurring talk of the euro as an alternative reserve currency. What is important to remember is that this is currently a crisis for the EU and not yet for the EMU. The European Monetary Union is the 12 countries that share a common currency, while the EU includes non-Eurozone countries such as the UK. The euro has very much become a part of the lives of Europeans. The costs of growth and the costs of dismantling the euro and reprinting individual currencies could throw the Eurozone into an even bigger crisis.

Don’t Expect ECB To Lower Rates To Help Dollar

In the second half of the year, the pressure on the ECB to cut rates is even stronger than it was during the first half of the year. Many politicians as well as the IMF have called for the ECB to lower rates to spur growth. ECB President Trichet remain steadfast in his stance that the central bank remains "vigilant and realistic" and is not "preparing the market for any rate decrease." Many have said that Sweden’s surprise rate cut and the Bank of England’s shift in stance will add pressure on the ECB to cut rates. This is highly unlikely though since Sweden is in a very different position than many of its counterparts. In contrast to the Eurozone, Sweden is facing deflationary pressures. Annualized inflation fell to 0.2% YoY last month from 0.4% in April. Inflation in the Eurozone on the other hand was 1.9% last month. Both countries are facing weak growth of comparable levels and have a 2.0% inflation target. The numbers alone though tell us that Sweden has a much more pressing reason to lower rates than the ECB. With oil prices up 29% from May’s low, and the EURUSD 7% lower, we will probably see inflation either back or above the central bank’s target. Despite the persistent calls for a rate cut, this will keep the ECB’s hands tied for the time being. The diverging monetary policies between Europe and the US will continue to lend support to the dollar until the Fed shifts back to neutral, after which time we could see the next big move in the dollar.

Technical Outlook

As time marches on, all good things must come to an end. The last six months have seen the dollar begin to re-exert its dominance once again upon the majors, with the euro breaking the trendline that dominated the price action since middle of 2002.

As the euro continues to tumble, with the latest swing aiming for the 1.2000 figure, a 2004 summer range low, market participants should expect more volatility to be present in the market, a condition that materializes whenever a strong trending market changes its course.

The failure by the single currency to retest its all time high at 1.3667 added to the outlook that the once all powerful euro is losing its dominance.

The price action for the next six months will most likely see a strong trending market with a break below 1.20 possibly extending a move down to 1.17, while a break back above 1.24 could give the pair room to head back towards 1.30. In the near-term, the Euro remains confined to a downward sloping regression channel with the latest swing failing to penetrate the trio of EMA’s and bounced off the median regression line. As the pair continues to consolidate, indicators point a possible trend reversal. Stochastic is neutral at 31.18. ATR is rising as the volatility picked up, following a March-May dollar rally, signaling an intermediate bottom. ADX (DMI) fell to 35.18, signaling weakening in the trend.

USDJPY Outlook

Dollar/Yen seems to have very much become the “new” carry trade of the year. With Japan offering zero interest, it is not surprising that it tops the list as the currency to sell for carry trades. The dollar on the other hand offered an increasingly higher interest rate throughout the course of this year, making the USDJPY pair the near perfect choice for this year’s emerging carry trade. Japan’s economic performance in the first half of the year has been far from impressive. Growth has accelerated in the first quarter (remember Japan is on a different schedule from the US), with consumer spending rebounding. However, exports have fallen, especially to China while deflation remains a major concern. Japan’s growth also seems to be closely tied to the fluctuations in oil prices since Japan imports over 90% of its oil. The country’s citizens are already notorious savers and rarely spend, which means that higher energy costs will take an even bigger bite out of domestic spending. All of the economic data that we saw in the month of May showed signs of improvement, but at the same time, oil prices also trended lower for most of the month hitting a low of $46.20. Things should look very different in June, when Japan, along with the rest of the world has to deal with oil at $60 a barrel.

Bank of Japan Considers Raising Rates

Yet in the face of all this, the Bank of Japan has already begun talks of raising rates. In the past few central bank meetings, Mr. T. Fukuma has proposed to cut the reserve target range to 27-32 trillion yen, but as revealed in the minutes, he has consistently failed with only two votes supporting the proposal. In May, the statement was amended to include the possibility of the balance falling short of the target in times of “exceptionally weak” demand. This additional sentence was preserved in the June release after the target was breached twice on June 2 and 3. With the statement reappearing in the policy announcements and CPI peaking above the 0% mark, the Bank of Japan is slowly building on the notion they will be ready for positive short-term rates. In June, BoJ Deputy Governor Muto said that, "I believe chances will grow for a shift in the policy framework in fiscal 2006/07, but we are unsure whether we will actually go ahead with a change." If the Bank of Japan does begin raising rates, this could have significant ramifications for the Yen. A tremendous amount of speculators are still short yen for carry trades. A rate hike could trigger extensive profit taking, which would be bearish for USDJPY, especially if this comes at a time when the US is done raising rates.

Keep Watching Chinese Revaluation

Talk of Chinese revaluation has subsided a bit in the beginning of the summer, which has helped spur some of the USDJPY rally. However, revaluation still remains a pressing concern. China's move towards Yuan convertibility is particularly important for Japan and USDJPY. Since the Yuan is not readily available for trading by individual speculators, many traders have opted to express their views through the Japanese yen instead. USDCNY forwards have a very close relationship with USDJPY, which substantiates the usage of USDJPY to express views on the Yuan. In fact, between January 2003 and January 2005, the correlation between 6-month USDCNY forward rates and USDJPY was over 80%. The selection of this pair as a trading alternative stems from Japan's close ties with China. As a net exporter, Japan competes heavily with China. China's artificial suppression of the Yuan has forced Japan to intervene aggressive to artificially depress their own currency throughout 2003 and early 2004. Although Japanese authorities have been absent from the market for the past few months, the market is still cautious as the possibility of government intervention looms, especially considering that the dollar is still hovering at 5 year lows against the yen. The undervaluation of the yuan creates a significant disadvantage for the rest of the G7. The severe negative economic consequences of the undervaluation have forced other G7 countries to pressure China to revalue their currency.

Dual Forces Keeping USDJPY Moves Limited

As a result, dual forces are keeping moves in USDJPY limited. On the upside, the threat of Chinese revaluation still remains in the mind of traders, keeping gains limited. On the downside, carry trade demand keeps USDJPY well bid. The third caveat is of course oil prices, which also has been positive for dollars and negative for yen.

Technical Outlook

The sun is setting on the Japanese yen with the Dollar breaking all of the major trends that drove the price action for a number of years. The last six month saw the yen consolidating within a trading range that the pair established following the failure to break below 101.70, a five year low. The trend has reversed and now we have USDJPY trading above 108. The last time the Japanese yen was this strong against the dollar was 1999, when the dollar bottomed out at 101.30. History is in the process of repeating itself given the cyclical nature of the markets. So far, the currency pair has made a new 2005 high and has been holding above the 108 level fairly well.

Yen fell back after establishing a new 2005 high, but the pair failed to break below the 108.00 figure. As the price action remains subdued, dollar bulls will most likely push the pair toward the 109.50 line, with the further move to the upside most likely capped by a new 2005 high. Indicators point to a weakening trend. Stochastic is dipping below the overbought line at 74.59. ATR is indicating a drop in volatility. ADX (DMI) is at 24.95, signaling a slowing trend. A break above 110 could see the pair test the 115 level, while a break back below 105 would be needed for any chance at testing the 5 year low.

GBPUSD Outlook

Like the Euro, the British Pound has also taken a sharp slide against the dollar. The fundamentals behind the GBPUSD’s slide are very different from that of the EURUSD. For the British pound, we are finally seeing, what we knew would happen sooner or later. After raising interest 5 times last year, the UK’s impressive growth showed no signs of slowing. This continued to be true for most of the first half of 2005 with most economic data sending mixed signals. It was only in May of this year that we finally had some directional clarity on the health of the UK economy. Consumer spending has slowed and housing market indicators are collectively pointing to a slowdown in the sector. Meanwhile the trade deficit has also widened causing some concern for export demand while the inflation risk according to the central bank was tilted towards the downside as of the beginning of June. These developments have prompted two monetary policy committee members to vote in favor of lowering rates at the June 8/9 meeting.

BoE Changes Course – Talk Of Rate Cuts Sends Pound Tumbling

You can either call the Bank of England fickle or dynamic, but there seems to be a lot of dissent and shift in views over the past few months. In March and April of 2005, the decision to keep rates unchanged was also 7 to 2, but the 2 dissenters voted in favor of raising rates. In May, one of them moved back to neutral camp, leaving only one favoring a rate hike. In June, the remaining hawk voted in favor of keeping rates unchanged while 2 different members voted in favor of lowering rates. So for the time being, the BoE is neutral with a dovish bias, yet as we have seen, this could change rather quickly over the next few months if the trend of economic data also changes.

Carry Traders Getting Out

The monetary policy bias of the central bank is particularly important for the British pound because GBP crosses are laden with speculators. Although there are countries and currencies that offer higher interest rates than the UK offers, the pound has traditionally been one of the favorite currencies for speculators to go long for carry trades. The UK offered not only 4.75% interest rate differentials and were amongst one of the first to raise rates, they also offered one of the most liquid financial markets in the world. For large hedge funds that are also involved in the carry trade, this is particularly important as they may actually end up buying pound denominated investments after converting their dollars to pounds. Through 2003 and 2004, the UK was also one of the most resilient economies among the world’s industrial leaders. Unemployment remained low while the country enjoyed 44 consecutive quarters of expansion – the longest period of uninterrupted growth for the country in over 200 years. In fact, the UK was the only G-7 nation to avoid a recession in the last 5 years. For the time being, with the US raising rates and the UK standing pat, the carry trade differential continues to shrink, giving carry trade speculators a good reason to take profits. If the BoE actually does lower rates, the sell-off in the GBPUSD could exacerbate, as any remaining speculators will capitulate. Keep watching the trend of data and the central bank’s bias for more insight on the future direction of the GBPUSD.

Blair Slated To Take Up EU Presidency

One interesting development to watch will what Blair does with the EU Presidency that his country is slated to take over in July of 2005. So far, the EU is in crisis, with the UK leading the pack of those who refuse to budge. At the EU Summit in June, the UK and France spent the whole time fighting over rebates and agricultural subsidies and not the future on the European Union. Although acknowledging that their rebates were an anomaly that needs to be fixed, the UK refuses to give up the rebates unless France overhauls their agricultural subsidies, which they call another anomaly. It will be interesting to see how Blair’s camp tries to fix things because this time, they are going to be held accountable.

Technical Outlook

Sterling lost a lot of the shine that it had during the first six months of 2005, after the pair reached a multi year high at 1.9550 and then proceeded to collapse down to 1.8000. It is now attempting to retrace from those lows, but has repeatedly failed to break above the 1.8300 figure that is marked by a 61.8 Fibonacci retracement. A break above the 1.83 level could lead to an extension move to 1.86, while a break below the 1.81 level will send the pair down to 1.80, and the 1.77 level. Indicators are currently pointing to a possible trend reversal. Stochastic is neutral at 57.18. ATR is rising as volatility picked up, signaling an intermediate bottom. ADX (DMI) is at 27.50 and falling, signaling a trend reversal, with DI+ about to cross above the DI- thus issuing a buy signal.

USDCHF Outlook

Things Not Really Improving All That Much

Dampened by rising oil prices towards the end of 2004, Swiss economic growth prospects still remained under pressure in the first half of 2005. Things haven’t improved all that much in Switzerland since our last report forcing the central bank to downgrade their real GDP growth estimates to 1.0% from 1.5% set in March. Reasons for the downgrade were three-fold. First, was the stagnant GDP growth in the first quarter over the previous three months due to a slack in exports. At the same time factors outside of Switzerland acted as a drag on the world economy. Oil proceeded to return to lofty levels in June after easing off of a record high in the previous two months. Exorbitant oil prices were particularly unfavorable for Europe, the biggest consumer of Swiss exports and finally, the level for uncertainty has increased overall since the Swiss National Bank’s assessment back in March.
Looking at actual numbers itself, GDP growth was flat in the first quarter after contracting 0.1% in the fourth quarter of last year. Industrial production also contracted 6.5% in the Q1 with the purchasing managers index hovering just above the 50 contraction / expansion line. Inflation on both a producer and consumer level fell in May, leaving the higher trade balance as the only piece of good news.

Swiss Franc Benefits From Flight To Safety

Yet the Swiss Franc remains very strong as a result of flight to safety. The uncertainty in Europe has caused many holders of Euros to convert their assets to Swiss francs or Gold. Given that Switzerland currency use to be backed 40% by gold, the two now have an 80 to 90 percent positive correlation. The recent rally in Gold has helped to spur sharp gains in the Swiss franc against the euro.

SNB Prepared To Raise Rates

The Swiss National Bank continues to hold onto their unchanged neutral monetary policy but they remain ready to act if the economy improves. In June, SNB directorate member Hildebrand said that, "If the economy does recover, as we would expect it to do in the quarters to come, then the current monetary policy stance is not compatible with long-term price stability. We have room to be patient given our inflation forecast. There are a number of indications that suggest the recovery should proceed in the quarters to come, but as we pointed out today, the level of uncertainty is relatively high. Leading indicator developments in Switzerland [are] promising. We have PMI data suggesting the deterioration has ended...We also have credit data that suggest lending activities are increasing, not just on the real estate side, but also to businesses." So as you can see, even though growth has been weak, the SNB still retains a mildly hawkish bias.

Technical Outlook

The Swiss Franc has rallied significantly since the beginning of the year. The latest move by Swissie bears has pushed the pair above the trendline that supported the downward momentum for the past 4 years. Following a failure by the Swissie bulls to hold the 1.1300 figure and the break in the trendline, the 1.30 level is now in reach. A break back below 1.24 could see a move back down to 1.20. Meanwhile, stochastics are dipping below the overbought line at 73.44. ATR is rising pointing to growing volatility, and ADX (DMI) is at 38.84 indicating maturing trend.

USDCAD Outlook

It seems as if it was only yesterday that the Canadian dollar was hitting 12-year highs against the US dollar on prospects of more interest rate hikes, rising oil prices and a tight labor market. Since then the tables have turned and the Loonie has given back 600 pips of those gains against the greenback over the past 6 months. Growth has gradually improved since September of 2004 and the recent rally in oil prices has given the CAD renewed strength.

Politics Weighed On Loonie in First Half - One Deciding Vote Secures Martin’s Post

After a tense and extremely close federal budget vote, Canada’s Prime Minister, Paul Martin and his Liberal Party have managed to escape new elections and retain their political positions until at least early 2006. The vote, which took place on May 19th, was more than just a routine budgetary ballot; it paralleled as a vote of no confidence, with Martin stating that if his budget did not pass, he would call early elections and step down from his position as Prime Minister. The political turmoil has been raging in Canada for months due to the surfacing of a government advertising scandal in Quebec. Although the loitering of funds took place while the former administration was in power, it occurred under the watch of a Liberal government. Furthermore, Martin was serving as finance minister at the time.

The vote itself was extraordinarily close, with the Liberals winning by one vote in the House of Commons. Moreover, the victory only occurred because generous concessions were granted and unrelated political cards played to defeat members of opposing parties. The support of former conservative leader, Belinda Stronach was especially important for Martin’s victory, along with a few key independent voters. The leftist New Democratic party was also a large part of the Liberal’s victory. However, with their support came compromises in the form of greater government spending. This could be a source of trouble in the future as the increased funding of education and environmental related projects has the potential to threaten the balanced budget and is already drawing huge amounts of criticism from the Conservative Party and the Bloc Quebecois.

Martin might have been able to get his budget passed, but that does not mean his political drama is ending any time soon. Analysts speculate that this ordeal is far from over. The Canadian government remains exceedingly fragmented; an atmosphere that will not be conducive to effective governing. Along with this, Conservative and Bloc Québécois leaders, seeing a very vulnerable party in power, are stepping up their efforts for the 2006 elections. This ongoing tumultuous political situation has left investors wary. Even after the incumbent government has managed to ward off their adversaries, their position is far from secure and their opponents feel far from defeated.

But Reverse Course In Oil Prices Spur Optimism

Being the ninth largest producer of crude oil in the world, Canada’s currency has a strong positive correlation with oil prices. In fact, over the past year, the weekly correlation has been close to 70%. This means that if oil prices rally, the Canadian dollar also has a high likelihood of rallying. The renewed strength in oil and the break above $60 a barrel has proved to be very positive for the CAD. If oil prices continue to rally, the loonie should do so as well. However at some point, the benefits begin to subside as higher oil prices will take a significant toll on US consumer spending. The US is Canada’s largest trading partner and weaker growth and spending in the US will certainly also be felt up North.

China

Yet all hope is not lost. China is Canada’s second largest trade partner next to the United States. Between 2003 and 2004, exports to China increased 38.6%, with the world’s most populated country growing by 9.5% in the first quarter of 2005. There are no signs that the Asian giant is slowing. This is even truer in regards to China’s demand for commodities. China is just beginning to embark on its path of modernization. Even though they have a population of 1.3 billion people, 4 times more than the US, their consumption of core commodities are still relatively smaller than their more industrialized peers. As the country continues to grow and increase productivity, its demand for commodities is expected to increase as well. This long-term source of demand will continue to support the industries of heavy commodity exporters such as Canada, which will keep USDCAD gains limited.

Technical Outlook

Early 2005 proved to be a turning point for many currencies including the Canadian dollar, which hit a 12-year high against the US dollar during the end of last year. The previous six months have seen the pair climb toward the 1.3000 figure, but fail to break above the trendline that dominated the price action since late 2002. As a result, the price action for the next six months will most likely consist of range trading with a clearly marked top and bottom at 1.1700 and 1.2800. As the price continues to fluctuate within an ever tightening range, the last quarter of the year will most likely see the pair stage a breakout above the 1.3000 figure.
Indicators signal range-trading conditions with Stochastic dipping below the overbought line at 74.38. ATR is in the mid-range with the weekly range exceeding 200-pips. ADX (DMI) added to the range trading outlook with DI+ and DI- continually crossing each other, thus constantly issuing buy and sell signals, which is indicative of range trading.

AUDUSD Outlook

In contrast to many of the other majors, the Australian Dollar has held up very well in the face of the strong dollar rally that characterized the first half of this year. The strength has been a result of many reasons including a surprise interest rate hike by the Reserve Bank of Australia in March, keeping carry traders in, soaring commodity prices and long-term Chinese demand. Although rising commodity prices make Australian exports more expensive, unrelenting demand from industrializing nations, especially China, have kept the effects of this fairly low. The strength of the AUD has also given Australians the chance to buy cheaper goods from other countries and the consumers have embraced this opportunity. Yet despite what should be stronger corporate profits, the economy as a whole has not been performing fantastically. Although the current unemployment rate still stands at a 25-year low of 5.1%, growth in the labor market is definitely headed downwards. After 6 months of increase out of the latter 7 months in 2005, job ads declined 4 out of the last 5 months with the most recent one being an alarming -7.3%, the largest since April 2003. The effects can be seen as change in employment seems to have peaked in early 2005. After monthly gains upwards of 50,000 in the first quarter, April and May saw 19,900 and 14,000 jobs created respectively.

The labor market appears to be losing steam and the March 25bp interest rate hike has made its way to consumer spending. Retail sales fell in April, the first time in 2005, by 0.5%. The problems seem to stem from the skyrocketing growth that occurred in 2004. During this process, many capacity issues came up for firms. Although wage growth has been tame, slower labor productivity has pushed unit labor costs up and has made companies slightly wary about hiring although business confidence is up. Yet the sliver lining is that business investment is gradually improving. The push that the economy has experienced has managed to uncover many structural flaws, one of which is transport bottlenecks, which limited commodity exports recently. With low corporate debt levels and healthy business confidence, firms will have every means to bend to the needs of production capacity. In time, this will increase labor productivity and hiring could be on the rise again towards year-end and going into 2006. This means that although household spending will remain contained in the next few months, it won’t stay that way for too long. To add to this argument, the recent government surpluses have made their way into the budget as tax cuts in both personal and business incomes.

Expect RBA To Keep Rates Unchanged

With a GDP slowdown in the works, the Reserve Bank of Australia will most likely put the brakes on any further monetary tightening for the year. The current rate of 5.50% should be enough to keep inflation within the 2-3% inflation target range kept by the central bank. In terms of consumer spending, the expected deceleration shouldn’t put any pressures on inflation. The current level of the Australian dollar is also ensuring that import prices remain low. Any risks come from constraints on output growth. With the economy operating so close to capacity, demand, even if it is lowering, becomes relative. If companies just aren’t able to churn out enough goods, prices will rise, as elementary economics dictates. However, assuming that these risks don’t pan out, the current interest rate is sitting in the RBA’s “neutral” long-term stability range of 5-6.25% and isn’t likely to head anywhere in the near future. With the US ready to raise rates in the latter half of this year, the positive interest differential that the Australian dollar is enjoying will surely be eroded. The biggest risk to the upside would be a recovering in residential investment coming before it’s expected. Meanwhile, the same upside risk for interest rates will be a downside risk to GDP. In a country so reliant on loans with the household debt at record levels, the effects from even a small increase in interest rates will certainly be widespread.

Watch Gold Prices

The fate of the Australian dollar is highly dependent on what lies ahead for gold prices. As the world’s third largest producer of gold in 2004, just barely behind the US, the currency moves fairly in line with the commodity. Going into June, gold has pushed back up towards $440/oz again, making it the third peak this year. Some analysts find it quite likely that the precious metal will approach historical highs once again. If so, the AUD is likely to demonstrate a repeat of last year’s activity.

Technical Outlook

The Australian dollar is a phenomenon compared to the other majors as the pair remains near multi year highs with the Aussie holding the trendline that dominated the price action since the middle of 2002. The previous six months have seen the pair confined to a trading range with .7500 acting as a strong resistance and .8000 confining the Australian dollar to a 500 pip range.

The psychologically important .8000 level is acting as a ceiling for Aussie bulls. The next six months might see interesting price action developing as the Australian dollar might try its luck and push the pair above the .8000 figure, thus breaking a multi year resistance. The breakout has a potential to turn into a new trend, which may take the pair all the way up to .8500 figure, a high the pair has not seen for over a decade. A break below the trendline on the other hand will most likely see a trend reversal in the pair with the Aussie relinquishing the control of the price action to the greenback.

Indicators point to range trading conditions with Stochastic rising above the oversold line. ATR is falling as range is beginning to shrink, a pre-breakout/breakdown setup. ADX (DMI) added to the range trading outlook with DI+ and DI- continually crossing each other, thus constantly issuing buy and sell signals, which is indicative of range trading.

NZDUSD Outlook

After achieving nearly 5% GDP growth in the previous year, New Zealand is headed for a slight slowdown in 2005. Although first quarter GDP is expected to show a 0.8% expansion over the quarter, with the central bank expecting 1%, it is a rather small figure compared to the 2.1% achieved in the same quarter of last year. The effects of the Reserve Bank of New Zealand’s interest rate increases, totaling 1.75 percentage points since early 2004, are now being seen in the economy. The unemployment rate grew to 3.9% in the March quarter after falling to 3.6% in the December 2004 quarter. On the other hand, due to shortages in certain occupations, salaries and wages continued to grow 2.5% on a year to year basis in the first quarter of 2005.

Interest Rate Hikes Being Felt

Firms are already feeling the pinch from the higher interest rates as business confidence hit a new low of -56.7% in May after reaching -48.0% in April. Meanwhile, the higher borrowing costs haven’t had the same sharp effect in the housing market. Although a dip was seen in April, total sales value was back up to NZ$3,023.7M in May. This, along with the aforementioned wage increases, are part of the reason that inflation is still high, despite the central bank’s efforts to contain it. The latest CPI release put the annual price increase at 2.8%, just below the RBNZ inflation target’s upper limit, for the year ending in March 2005. Most of the inflation pressure is still domestic as the tradable price component decreased 0.5% in the quarter due to the NZD consistently rising to new highs near 0.7450 in March. As for the elevated current account balance, there will be a large bit of relief granted in the first quarter from an improved trade balance from a seasonal effect. However, the much larger investment income balance will remain NZ$2,413M in the red due to the repatriation of high profits earned by foreign-owned firms.

RBNZ on “Wait And See Mode”

The March rate hike, bringing the target rate to 6.75%, may have been RBNZ Governor Alan Bollard’s last. The monetary authorities are basically playing a waiting game now to see when the latest string of hikes will fully manifest itself as lowered demand. Lately, it seems that the economy has mostly been limited by capacity constraints. At the same time, while corporations will definitely factor the higher rates into their investment decisions, the effects might be less defined in the consumer market. About 75% of the loans presently taken out by New Zealanders are at fixed rates, which are more influenced by global bond yields that pull the costs down significantly lower than current floating rates. Since the latter half of 2003, the effective average mortgage rate has only risen 65 basis points. What this means is that the central bank will have to wait several more months for their rate hikes to hit housing prices, and in turn, consumer prices. Some risks pointing to another potential increase include a planned expansion in government spending, which will contribute to total domestic demand. Of course, it may be more important for the RBNZ to protect the economy from a hard landing by practicing patience for the remainder of the year.

Risks Exist on Both Side For Economy

The economy will continue to calm down during the rest of 2005. As demand eases and new business investment effects filter through, productivity will improve thereby relieving capacity utilization and pushing it down from recent highs. This implies that employment growth will slow down as firms require less workers to produce the required amount of goods. Taking the worrisome business confidence figures into account, it seems as if the economy could be headed downwards faster than is expected or desired. However, the comforting fiscal surplus ensures a nice spending package to support output if necessary. Also, currency adjustments are expected to balance out some of the changes in the economy. After having peaked twice in the first half of 2005, the NZD has few basic pressures working upon it. The closing interest rate differential will most certainly reduce demand for the currency as it loses carry trade advantage against the US dollar; the Fed is looking to increase rates while the RBNZ is sitting on the peak of its rate. Commodity and food prices, of course, are working in the other direction and could push the kiwi up. Although the NZD index for commodity prices was falling for a good portion of 2004, the decline was halted in January and prices are slowly rising once again.

Technical Outlook

The New Zealand dollar has remained relatively unchanged over the past six months as the pair continues to consolidate within a large triangle, while remaining far above the major trendline that has dominated the price action since middle of 2002. The next six months will most likely see the New Zealand dollar break below the triangle and aim for the major trendline below 0.70. A failure by Kiwi longs to hold up the currency will most likely result in the pair beginning to reverse its course and start a new greenback dominated trend. For the time being, indicators still point to range trading conditions with Stochastic treading along the oversold line. ATR is pointing to a rise in volatility, which remains historically high, with the pair maintaining 160-pip range on average over the past year. High volatility is usually indicative of trend reversals, which might be the case with the New Zealand dollar. ADX (DMI) is adding to a range trading setup with DI+ and DI- continually crossing each other, thus constantly issuing buy and sell signals