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A combination of measures will be required to narrow the US trade deficit gradually, including dollar depreciation in Asia, a lower US budget deficit and higher long-term US interest rates. Some progress on these fronts is realistic over the next year.

There is, however, a growing risk that the markets, politicians and investors will lose patience, especially if the deficit fails to respond this quarter. In this context, current indicators are worrying and point to a further near-term deficit widening due to fragile overseas growth, strong US import demand and high energy prices.

If the deficit rises further in the second quarter, there will be an increasing risk of escalating US trade protectionism pressure, a disorderly decline in the dollar and a US recession.

The dollar’s recovery over the past two weeks has lessened the immediate focus on the US trade deficit, but the issue will return to focus with the release of the February US trade data next week.

The January data remained weak with the deficit widening to US$58.27bn for the month, the second highest shortfall on record and a 4.5% monthly increase.

The US has a serious and long-standing problem in the manufacturing sector. Exports of manufactured goods rose to just over US$50bn in January, an increase of 11.3% over the year. Imports, however, increased 18.6% over the year. The US deficit with China also increased to US$15.2bn for the month.

The fact that the trade deficit has not narrowed despite the weak dollar will cause further surprise. An important factor to note is that the dollar has remained fixed against the Chinese yuan and there has also been only limited depreciation against the yen. Asia has, therefore, been successful in retaining the bulk of its competitive position.

Currency depreciation always acts with a delayed impact on the trade account as it takes time for prices to adjust and for trade patterns to respond. The initial impact of a weaker currency is to push up import prices which tends to inflate imports while it takes longer for exports to respond to the change in competitiveness. It is, however, uncertain how much value traditional theory has in the case of the US trade deficit, especially as much of the trade deficit is related to transactions between US multinationals based overseas and within the US. Their international transactions and shipments will have a significant impact in distorting the US trade balance and the net impact is probably to inflate the deficit.

There will be serious short-term concern that many important indicators are pointing in the wrong direction for the US trade deficit. US demand is still strong with consumer spending robust. The evidence on overseas growth suggests that demand may be weakening, with disappointing data from Japan and the Euro-zone over the past month. Energy costs are high which will widen the deficit and there has been no move on the Chinese currency peg. These factors combined could accelerate the near-term trade deterioration.

The high level of oil prices will continue to put upward pressure on the US trade deficit, especially as it is very difficult to reduce energy demand in the short term. Prices have been stuck above the US$50 p/b level this year and recently scaled 2005 highs above US$58 p/b. There will be particular concern if prices do not fall to below the US$50 p/b level within the next few weeks as there will start to be a serious impact on the US trade account as energy imports increase.

There will be serious concern over the level of demand in Europe and Japan. The latest PMI figures reported weak activity in the Euro-zone area, with manufacturing activity particularly weak. The Japanese demand figures have also been disappointing over the past few weeks. In this environment it will be very difficult for US manufacturers to boost exports as demand for US goods will not be strong enough. Conversely, the latest US growth figures have remained buoyant with strong ISM data for March.

It is possible to put a positive interpretation on this data as it could suggest that import substitution is finally taking effect. Under this scenario, increased demand for US-made goods is boosting US output and hurting the manufacturing sectors in Europe and Japan. This combination would start to narrow the US deficit.

Conversely, if Europe is facing difficulties because of weak internal demand, the implications are much less benign for the US trade account. US exporters will struggle as overseas demand falters. The trade figures over the next 2-3 months will be important in determining whether an optimistic view can be justified.

Expectations of higher US interest rates have offered dollar support. It is also the case that high interest rates will be an important element in curing US domestic demand and easing the upward pressure on the trade deficit. There will, however, be an increasing risk that confidence in the dollar will deteriorate sharply again before the trade account shows a significant improvement. A sharp dollar decline and upward pressure on interest rates would increase the risk that the US deficit imbalances will be reduced through a US recession rather than stronger overseas demand and rising exports.

On current trends, there will be a growing risk of protectionist measures. In January, for example, there was a 39% increase in Chinese apparel imports. In part this reflected the ending of world-wide limits on textile trade and there will be intense pressure for US manufacturers to impose new import quotas. The US political pressure for protectionist measures is likely to increase. Members of the US Senate and House of Representatives have already called for legislation to restrict imports from China and to impose import tariffs if China fails to revalue the yuan within the next six months.

The UK economic evidence remains mixed while the latest retail and housing data would suggest that interest rates may be high enough to control the economy. There are, however, significant inflation risks associated with the strength of government spending, tight labour market, rising earnings growth and strong liquidity creation. Globally, the trends also suggest that monetary conditions need to be tighter. Overall, the risks associated with a further small increase in interest rates look to be slightly lower than keeping rates on hold, especially as the bank can react quickly if necessary to cut rates over the second half of the year. It remains a close call, but a 0.25% May rate increase is realistic.

The Bank of England has left UK interest rates unchanged at 4.75% since August. The recent economic data has remained mixed with no decisive direction, but there has been evidence of a slowdown in consumer spending. According to the most recent data, monthly retail sales growth was held to 0.2% in February which cut the annual growth rate to 3.6% and the CBI retail survey reported March sales at a 6-month low. The latest household income survey reported that disposable incomes fell over the past year and this will undermine spending potential. It is, however, more difficult to assess the overall strength of consumer spending given the amount of spending outside the retail sector. The data, for example, may not be picking up increased internet buying. Consumer credit growth has eased slightly, but is still running at a high level.

The latest inflation data reported a headline consumer price increase of 1.6% in the year to February, still comfortably below the 2.0% Bank of England target level. The data does, however, exclude the impact of housing costs and the RPI-X rate is above 3.0%.

There will be concerns over earnings growth with the headline annual growth rate rising to 4.4% in February from 4.3%. The labour market is also still tight with low unemployment and this will maintain upward pressure on earnings growth.

Oil prices remain high at close to the US$55 p/b level and Sterling has also retreated back below the 1.90 level against the US currency. The import price trends are less benign than the first half of last year. Input prices, for example, rose 10.7% in the year to February and it will be increasingly difficult to prevent these costs increases being passed on if these cost pressures are sustained. The bank will certainly be worried if Sterling starts to weaken more significantly as this would intensify upward pressure on import prices.

The recent housing data had suggested that there has been a stabilisation in prices and a limited recovery in mortgage lending, although the evidence was far from conclusive. The latest Nationwide house price index, however, jolted markets slightly with a 0.6% monthly decline, the sharpest monthly drop for 6 years, while the annual growth rate slowed to 7.9%. Transactions remain relatively subdued and valuations remain very high in historic terms. The conflicting data is typical of a market that is close to a peak. In this context, the crucial Spring trends in the market will be very important for the housing market and economy as a whole. The bank will want to achieve a controlled slowdown in the housing sector, although it will be very difficult to use interest rates this precisely. Overall, the latest evidence increases the possibility that interest rates are high enough to stop further significant house price rises.

The March government budget was slightly more restrictive than expected, but spending is still set to retain the strong growth seen over the past three years and the government will need firm GDP growth to meet its deficit targets. The latest borrowing data showed an increase in central government spending of 8.4% in the year to February, comfortably above nominal GDP growth. Given the potential inflation impact from the expansionary fiscal policy, the government may have to pay the price of persistent strong spending growth in the form of higher interest rates.

The latest money supply growth figures recorded annual growth of 9.5% in the year to February compared with 9.3% in January and the overall pace of monetary creation suggests that a further increase in interest rates is appropriate.

Political considerations will be significant with an election almost certain in May. There will be some significant central bank caution in increasing interest rates next week if an election has already been called.

There will be further US inflation concerns in the short term after the higher than expected inflation data this week, although in historic terms the pressures are still relatively mild. The Fed is probably regretting waiting so long before increasing interest rates last year, but a sudden and panicked more to accelerate monetary tightening now would be counter-productive given the degree of the inflation threat. A gradual increase in interest rates will still be in the best interests of the US and global economy.

Weaker growth data would increase speculation over stagflation and this would pose much greater threat to the US economy. If there is greater evidence of stagflation over the next few months, confidence in US bonds, equities and the dollar could be seriously damaged. There is also likely to be a robust debate on the merits of inflation targeting.

US inflation concerns have been a significant focus over the past week, particularly with the release of monthly price data and the meeting of the Federal Reserve interest rate setting committee.

The inflation figures caused concerns with headline consumer prices rising 0.4% in February, the largest monthly increase for September. The annual rate increased to 3.0% and, although this was still lower than the 3.5% seen in November 2004, the underlying annual rate was running at the highest rate since May 2002. Within the inflation figures, there were significant monthly increases for transport, housing and medical costs. The rise in transport costs will be due in part to rising oil prices and energy costs are an important factor behind the inflation rise. There will, however, also be greater concerns over a more general rise in services-sector inflationary pressure.

Producer prices rose 0.4% in February, pushing the annual increase to 4.7%. The underlying increase at 2.8% was the biggest increase since November 1995. The rise in inflation will invite speculation that the Fed kept monetary policy loose for too long and will create fears that the central bank will now find it very difficult to contain inflationary pressure without a more aggressive monetary tightening.

There will be further concerns over imported inflation pressure with import prices rising by a further 0.8% for February. Oil prices have eased over the past few days, helped by a dollar rebound, but prices are still close to US$55 p/b. The rise in energy costs will inevitably have an impact on inflation and sustained increases in energy prices would increase the risk of wider inflationary pressure as it becomes more difficult to avoid passing on cost increases.

The persistent dollar weakness over the past two years will also pose inflation risks, although the US is less vulnerable than other economies in this respect. The traded-goods sector is a smaller proportion of the economy and many commodity prices are also priced in dollars which lessens the potential inflationary impact on the US economy.

The Federal Reserve is wary over rising inflationary pressure and is also concerned that companies have a greater ability to pass on cost increases. There is, however, still very tough competition in the traded-goods sector which will limit inflation concerns. The Fed will consider a faster pace of monetary tightening, but great care will be needed, particularly as the Fed needs to retain domestic and overseas confidence in US monetary policy. A more aggressive tightening could be seen as a tacit admission that the Fed had got policy wrong and this could act to destabilise market confidence in Fed policy, especially if bond yields rose sharply. The Fed will also need to maintain as smooth a policy as possible to bring about a controlled adjustment of US imbalances.

The latest money supply figures do not suggest excess liquidity. Narrow M1 money supply increased only 3.9% in the year to February while there was a 5.5% increase in broad money supply growth. Money supply growth at this level does not suggest excess liquidity creation.

There will be concern over the risk of inflation in the housing sector, especially as prices have increased rapidly over the past two years. Property inflation is, however, due primarily to low long-term rates, partly as a result of Asian bond buying. There are uncertain linkages between housing-sector inflation and more general price inflation. Nevertheless, the housing inflation does suggest that liquidity has been too loose over the past two years. Rising bond yields will be an important element in helping to curb domestic inflationary pressure.

A more worrying interpretation for the US economy is that inflationary pressure will rise at the same time as growth in the economy slows. Such a development could put the Fed in an extremely difficult position from mid year. The need to increase interest rats to combat inflation would be in direct opposition to the pressures for low interest rates to sustain growth and maintain full employment. The risks for the US will be increased by the fact that there is very little room for manoeuvre on fiscal policy.

A trend towards rising inflation would also ensure a very tough debate on the subject of inflation targeting for the US Fed. Stagflation would also severely erode confidence in US assets and the dollar.

Underlying pressure for a yuan revaluation will persist over the next few months. The Chinese authorities still need to avoid a free float and a realistic compromise would be for a switch to a trade-weighted basket with a gradual widening of the yuan trading band.

There will be a strong temptation to avoid change given the potential capital-account volatility and perceived benefits of inertia, but there are growing domestic and regional risks from the build up of reserves and intervention to prevent regional currency gains.

Further delays would risk more serious regional inflationary pressure, the need for an aggressive monetary tightening and, eventually, an Asian recession. Overall, the dangers of delay now look greater than the risks of measured changes.

The flurry of remarks from Chinese central bank officials suggest that the authorities are moving closer to a yuan policy shift. So far, however, there is still resistance to a shift away from the effective currency peg and the overall impression given is that they would prefer not to alter the peg.

The latest balance of payments figures reported that China had a capital account surplus of over US$111bn in 2004 with a current account surplus of US$70bn. China, therefore, bought close to US$200bn during 2004 to stem upward pressure on the yuan. It will be increasingly difficult to mange these inflows and avoid a further destabilisation of the financial sector and domestic economy.

The Chinese authorities are aiming to alleviate capital account pressures by offering greater freedom to the capital account and promoting outflows. Insurance companies, for example, will be able to invest overseas There will be measures to boost overseas direct investment and a limited issue of yuan-denominated bonds will also be permitted. China will still find it difficult to curb capital inflows.

It will also be increasingly untenable to maintain a fixed yuan peg at the same time as allowing increased capital account freedom.

The strong investment inflows will also pose significant inflation risks. The evidence so far suggests that the pressures are manageable with headline consumer inflation below 4.0%, but there will be an increasing risk of hidden inflationary pressure. Investment levels also remain strong and there will be further pressure for an increase in interest rates. Higher rates would increase the risk of speculative inflows, although this risk will be offset by rising US interest rates.

Regional economies remain extremely sensitive to China’s export competitiveness and there is a continuing resistance to significant currency appreciation throughout the region. South Korea, for example, has been intervening again over the past week to stem won gains. Trade surplus are continuing to create excess dollars in Asia and this is forcing central banks to increase dollar reserves.

Allied with strong investment inflows, there will be an increased risk of overheating in local economies. Eventually, this could force a sharp increase in interest rates and risk a regional recession. Although the situation is not critical, it will be increasingly dangerous to maintain an intervention policy. The build up of reserves will also increase the risk of currency-market volatility which could destabilise regional economies.

There will still be heavy opposition to a free float and this would certainly not be a sensible policy move in the foreseeable future. The Chinese economy would not be able to manage the financial pressures and economic stability would be a high risk. The authorities are, therefore, left with the possibilities of a new peg at a stronger rate against the dollar, a wider trading band or a switch to a trade-weighted basket. There would also be the potential for combining these policies.

There are clear dangers in a gradualist approach as there could be an increase in speculative inflows on expectations of a further widening and these fears will increase the attractiveness of resisting a policy change.

If China delays too long and there is a switch to a trade-weighted basket, there will be the intriguing prospect that the yuan could actually weaken against the dollar. If the Chinese authorities hold off from a revaluation until the dollar has weakened further on a trade-weighted basis, there would be the potential for a stronger US dollar after Chinese reform measures have been announced. Through the mechanism of a trade-weighted basket this would weaken the yuan against the dollar. This would be a particular risk if the Chinese economy started to show greater vulnerabilities. In this context, it would also be advisable for the Chinese authorities to take action sooner rather than later.

The economic fundamentals justify some strength for currencies such as the Australian dollar and greater confidence in emerging markets. Nevertheless, the overall behaviour of asset markets and prices suggests that excess global liquidity has encouraged a dangerous level of market interest in high-yield and emerging-market assets, especially as speculative interest in commodities has reinforced the trend. Markets are probably not discounting sufficient financial risk at current levels. The recent price trends also suggest that the global central bank monetary policies are not tight enough and, if this is the case, inflation fears will push long-term yields significantly higher as well as encouraging a further Fed tightening. As interest rates rise, there will be a high risk of a very sharp decline in commodity and high-yield currencies which could spread to emerging markets. Any evidence of financial stresses would risk a very sharp market adjustment.

The market is still showing very strong interest in high-yield investments and there are dangerous signs that a speculative bubble is forming.

The Australian dollar strengthened to near 0.80 against the US currency before a correction and the New Zealand dollar hit a 23-year high above the 0.74 level against the US currency this week. Although general US currency vulnerability certainly suggests that some US dollar depreciation is justified, there has been evidence of extreme speculative activity.

The number of long IMM Australian dollar positions, for example, has increased to a record high at over 50,000 contracts. Investors have also been willing to overlook substantial current account deficits in Australia and New Zealand over the past few months at the same time as fretting over the US current account deficit.

There are other signs of a speculative bubble developing. Over the past few weeks, the swap spreads over US Treasuries has fallen to multi-year lows and yield spreads on emerging market bonds has also dipped to the lowest levels since 1995. The markets have taken comfort from the fact that there have been no major financial shocks in emerging markets. There have also been improvements in sovereign ratings with credit upgrades outpacing downgrades by close to 3-1 over the past two years while growth rates have improved. Nevertheless, the yields have narrowed to an extent that is difficult to justify, particularly as the improvement may prove to be cyclical rather than structural.

There are, for example, also a record number of long speculative Mexican peso positions which has strengthened the Mexican peso to beyond 11.00 against the US currency. Overall indicators of risk aversion have also fallen to very low levels.

The strength of currencies such as the Australian and New Zealand dollars together with the South African rand have been linked with the strength of commodity prices. There have certainly been strong gains in commodity prices with the Reuters CRB index strengthening to a 24-year high this week. The difficulty is that investors are using the strength of commodity prices to justify buying commodity-linked currencies such as the Australian dollar. There are supply shortages in commodities such as copper which justify firm prices and Chinese demand is still strong, but the price increases still appear to have gone further than fundamentals would justify.

There is also a high risk that commodity price gains are, in turn, built upon speculation rather than fundamentals. If this is the situation, then the case for buying commodity currencies is also flawed and based upon a false premise. There will be a high risk of reinforcing declines in both asset categories on a cutting of speculative positions which could also lead to capitulation selling.

There will be a strong suspicion that the low and stable level of US Treasury yields over the past few months has encouraged a flow of funds into alternative and higher-yielding assets to boost returns. The Fed’s determination to supply sufficient liquidity to the global markets will have also contributed to a build up in speculative activity and increased risk taking.

If US yields rise, there will be less willingness to maintain these investments. Rising short-term US interest rates will also make it less attractive to borrow dollars and invest in high-yield assets. US bond yields have risen significantly this week with the 10-year rate above 4.50% and there will be the risk of a sharp market adjustment if inflation fears increase further. The US Federal Reserve also needs to slow global dollar supply and effective liquidity growth.

The overall behaviour of asset prices also suggests that central bank monetary policies have not been tight enough over the past 2 years. If wider inflationary pressure starts to build, there will be pressure for a more rapid pace of monetary tightening. A sharp rise in yields would increase the risk of casualties in the financial sector which, in turn, would sharply increase market risk aversion and pressure to cut high-yield positions.