Citigroup: Dollar expected to strengthen

The dollar and the yen likely will remain weak in the near term, but expect the dollar to strengthen somewhat (except against emerging Asia) as the U.S. economy regains momentum in the second half, according to the latest Citigroup Global Economic Outlook and Strategy.

By contrast, robust euro-area exports to emerging markets and hints of faster trend productivity growth in the region signal a higher trade-weighted trajectory for the euro over the medium term. Carry trades likely will remain popular amid low economic volatility.

In April, the dollar fell against all the majors except the yen, as data disappointments and the ongoing shakeout in the subprime sector of the U.S. mortgage market fed lingering investor worries about the depth and duration of the U.S. housing slump and its broader economic consequences. Our baseline forecast still foresees a return to trend growth in the second half of 2007 as the drag from housing fades. Along with easing inflation pressures hinted at by recent data, strengthening activity should again underscore the

attractiveness of U.S. assets, buoying the dollar.

Nevertheless, Citigroup analysts have pushed back and trimmed their expectation for dollar gains. The headwinds in the U.S. housing market are stronger than anticipated and may last into 2008. There are no convincing signs yet of spillover into broader consumer weakness, but corporate capital spending related to housing has softened notably.

Moreover, with the housing slump’s labor market fallout not yet over, and elevated energy prices likely to weigh on consumer spending, market uncertainty about the U.S.

outlook probably will remain elevated into the summer. In 2008, uncertainties associated with the U.S. election also may weigh on equities and the dollar.

Euro-area activity data repeatedly have surprised to the upside in recent weeks,

underpinning expectations for early ECB policy tightening and boosting the euro.

Economic growth in the region appears to have moderated much less than expected, as surging exports to rapidly growing emerging markets and oil exporting countries offset much of the drag from the January 1 German VAT hike, Italy’s fiscal restraint, and earlier monetary tightening. So, Citigroup have upgraded their euro-area growth forecast, with exports and strong profits likely to fuel robust corporate capital outlays, and possible further euro-supportive growth surprises. Yet, with low euro-area core inflation, there

appears to be little upside to market expectations for ECB tightening this year.

“Over the medium term, the euro likely will be stronger, on a real trade-weighted basis, than we had expected earlier, as healthy global growth continues to bolster commodity prices, emerging-world incomes, and demand for Europe’s exports. As a result, ECB policymakers increasingly appear to welcome a strong euro as a complement to higher interest rates. Moreover, labor markets hint at improved productivity performance that should, over time, boost potential economic growth and asset returns,” notes Citigroup analyst Gabriel de Kock.

Carry trades should remain attractive amid solid global growth and continued low economic volatility. Policy tightening is far advanced in many countries and growth rates are close to potential, allowing carry trades to exploit differences in neutral interest rates and limiting the risk of sharp interest rate moves. Heightened transparency also limits the risk of large policy surprises, barring unforeseen shocks. Against this backdrop, highyielding currencies like the Australian dollar, the New Zealand dollar, and sterling should perform well.

The yen remains the weakest of the major currencies. Yen undervaluation (by past norms) appears to reflect the BoJ’s highly accommodative stance, which has fueled capital outflows at a time when strong economic performance has underpinned Japanese investor attitudes toward risk-taking. Dovish BoJ rhetoric and falling core consumer prices likely will keep long-term JGB yields low, buoying the equity market and sustaining the yen’s status as the preeminent funding currency for carry trades. Gradual policy normalization eventually should undercut the yen carry trade, lifting JGB yields and the yen, but this scenario is unlikely to materialize before 2008.

Above-trend global growth and a modest rise in yields foreshadow ongoing support for commodity prices and commodity currencies. Among the G10 commodity currencies, the Australian dollar is well situated, as robust business investment has started to ease bottlenecks in Australia’s export pipeline, promising a rapid narrowing of the current account deficit. Higher energy prices are constructive for the Canadian dollar and Norwegian krone, reflecting the importance of oil in their export baskets. However, hard commodity prices have far overshot marginal production costs, pointing to an eventual

supply-driven correction that may pose challenges for commodity currencies over a twoto hree-year horizon.

Global imbalances will remain wide in 2007. Yet, Citigroup analysts do not view the U.S. external deficit as a key source of dollar weakness against the majors this year. As the U.S. economy picks up later in the year, robust performance by dollar assets should trigger portfolio shifts toward the United States that would more than offset the drag associated with the external deficit. Longer-term, however, we do not foresee U.S. debt and equities offering risk-adjusted returns that are consistently high enough to justify an ever-rising share of U.S. dollars in non-U.S. portfolios. Thus, the dollar should continue to fall on a trade-weighted basis over the long haul.

Over time, dollar weakness likely will shift toward emerging-market currencies, particularly in Asia. Facing international pressure and aiming to reduce China’s dependence on exports, the Chinese authorities likely will allow a steep yuan rise, which should spur policymakers in China’s competitors elsewhere in emerging Asia to allow faster currency appreciation, helping to slow unwanted capital inflows.