Currency market braced for another shake-out

"While the dollar was on a long falling trend, the markets gave intervention a well-deserved raspberry. But when the underlying forces are moving the other way intervention has a different result"

The currency markets have been swept by another of those waves of sentiment that excitable dealers in red braces seem to enjoy so much. The rush out of the dollar in the past two days has led to a dramatic fall in its value. But there is a good case for thinking it will be reversed before too long.

Economic fundamentals - although admittedly not in the vocabulary of many forex traders - have been pointing to a weaker yen and a stronger dollar for a long time, but never as convincingly as in the past few months.

Japan's trade surplus is falling, and will continue to do so as domestic growth recovers, pushing up imports. The US trade deficit expanded to a record in July, but its shortfall in trade with Japan has shrunk.

Moreover, the 16 per cent rise in exports during the first seven months of the year shows how competitive the US has become.

Flows of money point the same way. One of the excuses given for disappointment with the Japanese government's expansionary package was how little detail it contained about deregulation of capital flows to spur the departure of the country's capital surplus overseas. It was the hoarding of funds in the home currency that helped make the yen so overvalued. These details have been promised within the next 10 days. Progress on deregulation might be slow, but along with phenomenally low interest rates at home, it should at last boost investment in foreign markets by Japanese institutions.

The strongest reason for seeing this fall in the dollar as temporary is the new effectiveness of co-ordinated intervention by the US, Japanese and German central banks. While the dollar was on a long falling trend, the markets gave intervention a well-deserved raspberry. But when the underlying forces are moving the other way intervention has a different result: working with the grain of the market is effective, as the central banks' foray last month proved. The dollar climbed by 10 yen in August.

The banks have a breaking point at which they will intervene - even if it is only the level at which the dollar becomes an obvious bargain. And having finally figured out when intervention works it makes sense to wait for the same circumstances again. There are signs of interest from buyers in the market and plenty of funds which are short of dollars. Where a renewed dollar recovery will stop is another matter. The Japanese would like a range of Y100-Y110 but to expect the currency markets to allow that sort of fine-tuning is asking too much.