The dollar weakened back towards 1.20 in New York on a reduction in long dollar
positions. The Euro was unable to push through this level and… … held close to 1.1965
in early Europe on Thursday.

Interest rate expectations will remain important with markets still looking for a
series of rate increases from the Federal Reserve to combat inflation. Comments from
Fed governors Kohn and Fisher maintained the tough stance on Wednesday with both
governors pledging that action would be taken to contain price pressures. The Fed's
Beige book reported that growth was firm while energy prices had pushed up
inflation. The Fed will be worried by reports that companies were having some
success in passing on price increases and will remain on inflation alert. There
were, however, reports of weakness in retail spending within the Beige book and this
illustrates that there are growth risks to the US economy. The dollar will also
still be hampered by the fact that the US currency has already discounted a series
of rate increases and vulnerability will start to increase if there is evidence of a
more sustained downturn in spending.

There was evidence of further central bank Euro buying close to the 1.19 level on
Wednesday and this Euro support is likely to continue in the short term. ECB
Chairman Trichet also warned that the ECB would take decisive action if necessary,
effectively hinting over an interest rate increase, possibly this year. This will
offer Euro support and make it more difficult for the dollar to break resistance
levels.

As well as interest rate expectations, Fed officials Geithner and Pianalto chose to
focus on the US current account imbalances. Attention on the issues will tend to
increase if there is a sustained decline on Wall Street and this would tend to
expose the dollar to selling pressure, although there was a rally on Wednesday. Risk
tolerance will have a mixed impact on the dollar. A sell-off in emerging-market
investments on rising risk aversion would tend to support the dollar, especially if
there is a flow into US Treasuries, but the longer-term implications of a shift into
defensive currencies would be less benign for the dollar.

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