Markets: Dollar is ready to be quick off the mark

The US dollar has hit a speedbump after motoring ahead of the deutschmark for the past two and a half years, as the markets decided to take seriously the Bundesbank's threat to raise interest rates to bolster its currency.

But it is a speedbump rather than a roadblock, and investors are expecting the US currency rally that began in April 1995 to continue in the months ahead, putting the dollar on track to hit its highest level against the mark in 11 years.

The motor for the dollar's gains: evidence that growth in the world's largest economy is picking up steam, combined with concern that Europe's planned single currency, the euro, will be weaker than the mark.

The dollar has been on a roll since it dropped to a post-war low of 1.35 marks 30 months ago. After surging to an eight-year high of 1.8905 marks on 6 August, the dollar slipped as low as 1.7922 last week, trimming its gains against the German currency so far this year to about 15 per cent from 20 per cent. That's likely to prove a temporary pause, however.

"There had to be a consolidation in the dollar. The rally was too fast, too soon," said Thilo Steiger at AXA Fondsmanagement in Wiesbaden. "I don't think the dollar's rally has ended."

The dollar's gains have helped make US Treasuries one of the best-performing markets in the world this year, in dollar terms. Only some longer-term Canadian and Japanese bonds have done better.

A stronger dollar boosts the return on US securities for international investors, keeping foreign interest in the US stock market alive and helping to sustain Wall Street's climb.

"The potential is still there to go through 1.90 marks," said Keith Kelsall, manager at Fiduciary Trust International. "We're positioned toward a stronger dollar."

The dollar's climb has been broken in the past month by signs that the Bundesbank may be preparing the ground for its first increase in rates for five years. That, coupled with a slip in US stocks and bonds, prompted investors to pare their dollar holdings.

"A lot of investors have their pockets stuffed with dollars at the moment and want to get rid of them," said Andreas Rueger, a trader at Commerzbank. "However, the fundamentals still favour the dollar. I'm afraid we haven't seen the mark's absolute low yet."

Bundesbank president Hans Tietmeyer, breaking almost two months of silence last week, said he was "happier" with the mark's exchange rate now than he was earlier in the month. The German central bank has been alarmed by the speed with which its currency had lost ground against the dollar, though a weaker mark does help German exporters.

The dollar's gains were pared after a surge in German import prices in July to an eight-year high of 4.2 per cent, and bigger-than-expected gains in consumer prices in August, helped kindle concern over German rates.

Mr Tietmeyer, however, warned against "over-dramatising" the two price reports, pointing to a range of "special factors" that may not be repeated in the next few months.

He also denied a report by Deutsche Bank Research claiming the German central bank had sold as much as $2.8bn of its dollar reserves to prop up its flagging currency.

The Bundesbank first sparked rate-rise concerns a month ago, warning it was focusing on recent moves in the currency markets. With German economic growth lacklustre, however, economists reckon the central bank is loath to tighten monetary conditions.

At best, economists expect the German economy to have expanded by little more than 2 per cent in the second quarter. Figures last week, meanwhile, show that the US economy grew by 3.6 per cent in the same period - a revision of the government's initial 2.2 per cent growth estimate.

"The US economy continues to be strong while the conditions in Europe are very different," said Ulrich Hombrecher, chief economist at Westdeutsche Landesbank Girozentrale. "By the end of September, we could be looking at 1.85 marks to the dollar."

The key inspiration for investors to continue driving the dollar higher is likely to be concern that European politicians will keep plans to introduce a single currency in 1999 on track. To do that, they will probably abandon the strict economic entry criteria which even Germany and France are struggling to meet. Keeping budget deficits at 3 per cent or less of gross domestic product is proving difficult even for Europe's strongest economies.

And as the entry rules get relaxed, countries that have typically had weaker economies are likely to be founder members of the new currency, undermining its value.

"Mark weakness is all down to the euro. Everything is now pointing to a weaker euro," said Mr Kelsall of Fiduciary. "There is a high probability Spain will be in there, and Italy is not so much a question mark right now. All this does still point to a much weaker mark against the dollar."

Investors said these concerns about the value of the euro made a move to 2.00 marks per dollar - a level not seen since December 1986 - increasingly likely in the months ahead. "In the short term, we should see an exchange rate around the 2-mark level, whether it's 1.95 or 2.05," said Mr Steiger at AXA.

Copyright: IOS & Bloomberg