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Dollar Seen Steady as Risk Aversion Stays High

Reuters
Friday, 31 Aug 2007 | 3:04 PM ET

The safe-haven flow that has stabilized the dollar recently should persist next week as investors remain wary of risky assets, extending August's pattern of credit market turmoil feeding global demand for U.S. Treasuries.

But next week's load of economic data and key events could trigger wild swings in prices. Central banks in Canada and, more importanly, Europe are expected to keep interest rates on hold as they monitor the impact of the financial sector's volatility on their economies.

That could enhance the dollar's appeal even as the economic indicator calendar is heavy with data that will contribute to the Federal Reserve's decision on U.S. rates later in September.

Before the market turmoil, analysts had priced in interest rate hikes in the euro zone and Canada since their economies and housing sectors were perceived as much healthier than that in the United States.

"We continue to see risk aversion in the market next week, and the dollar could attract some bids, except against the yen due to its liquidity premium," said Shaun Osborne, chief currency strategist at TD Securities in Toronto.

The week culminates with the U.S. payrolls reading for August, probably the single most important data set so far this year, as investors look for signs the subprime mortgage debacle has infected the economy and employment.

"The August employment report will show some small evidence that the subprime mortgage crisis has begun to spill over into employment numbers," forecast Stephen Malyon, senior currency strategist, at Scotia Capital in Toronto. "It seemed that employment growth has begun to slow down and we will continue to see evidence that the process continues."

Wall Street economists expect new U.S. jobs of 110,000 for August, up from July's 92,000, according to a Reuters poll.

Malyon said the dollar's reaction will not only depend on the data's outcome, but also on how the U.S. equities markets view the report.

The dollar indexended August at around 80.77, little changed from the previous month, as investors fled riskier investments for the safety of dollar-denominated assets.

Investors are also expecting a key manufacturing survey from the Institute for Supply Management and the Federal Reserve's Beige Book survey. Analysts said the Beige Book report could prove to be more important than usual.

The Beige Book is based on information that comes directly from the Fed's business contacts and historically is one area where the central bank first sees signs of a shift in the economy. That should provide some indication of what effect the turmoil has had on the real economy.

In Europe, the ECB and Bank of England will hold monetary policy meetings and both are expected to hold rates steady.

Some analysts believe both are probably done tightening interest rates this year.

Monetary growth in the euro zone has accelerated while labor market conditions continued to be solid and these factors alone would have prompted a further ECB rate hike next week and supported the euro under normal conditions, analysts said.

"The global credit squeeze has pushed up borrowing costs even in the absence of that additional push to the repo target rate, making imminent action by the ECB less likely," said analysts from CIBC World Markets in Toronto.

"Odds now favour a pause at 4 percent, but the ECB will say it remains 'vigilant' on inflation, leaving an implied bias to tighten," they added.

The Bank of Canada will also meet next week to decide on interest rate policy, and analysts are expecting the bank to remain on hold. Analysts said the bank is less likely to match any rate cut by the Fed, partly because a U.S. measure to restore calm to its market will accomplish the same task in Canada. The Canadian economy is closely tied to that of the United States because of their trade links.

Elsewhere in the market, carry trades, in which investors borrow in a low-yielding currency such as the yen to invest in higher-yielding units such as as the Australian and New Zealand dollars, may not regain their earlier luster. Analysts still saw the yen trading in a seesaw fashion, as carry trades continue on an on-again, off-again pattern.