After a three-year decline, the dollar has recovered some ground in the first half of 2005, helped by the US Federal Reserve raising interest rates eight times in the past year.

As a result, US interest rates are higher than in Europe and Japan, and the interest rate differential has drawn foreign investment into the US bond market, boosting the dollar.

But foreign interest in safe-haven Treasury bonds has also helped to keep longer term US bond yields and home mortgage rates at historically low levels, fueling a home price boom.

``In the case of relative interest rate differentials, we get a divergence,'' said Anthony Chan, managing director and senior economist at JPMorgan Asset Management. ``Higher interest rate differentials are good for the dollar but bad for housing.''

Record numbers of new homes are being built in the United States, and house prices in many regions are at record highs, which recently prompted Federal Reserve chairman Alan Greenspan to warn of ``froth'' in the housing market.

The booming housing industry prompts demand for big-ticket items like furniture, washing machines and refrigerators to fill those new homes. Higher house prices also allow consumers to borrow more against the value of their homes to fund consumer spending and fuel economic growth.

But in the past decade, housing activity has become more sensitive to long-term rate changes, Chan said.

With many first-time home buyers priced out of the housing market, new home owners are pushing the limits of the debt servicing capacity by using interest-only loans and adjustable rate mortgages.

As interest rates are likely to rise further, according to Federal Reserve officials, fewer buyers are likely to be able to afford houses, slowing the housing industry's growth.

Many economists expect house prices to fall at least marginally on the lower demand, leaving consumers feeling less wealthy, much as they did after the stock market bubble burst in 2000. That decline in wealth should further reduce spending on houses and consumer goods, accelerating the economic slowdown.

``The inflation of the [housing] bubble is bullish for the economy, but its deflation is a potentially big negative for growth,'' said Ethan Harris, chief US economist at Lehman Brothers in New York. ``This piggy bank we're resting on is pretty fragile.''

Worse, unlike the stock market bubble, with US home ownership running at 69.1 percent in the first quarter, according to the Bureau of the Census, a decline in house prices would be felt across a wide swathe of the US population.

``The bubble will burst, and we will have a period like 1989-93, when many homeowners owed more than their houses were worth and could not sell out,'' said Peter Morici, a professor of economics and business at the University of Maryland.

``In some areas, where prices have been pushed too far, prices will drop.''

A slowing US economy may cause the Fed to stop raising US interest rates, lowering the allure of the US dollar for foreign investors, and allowing currency traders to again focus on the need for foreign capital to fund the US trade and current account deficits.

The US current account gap - the broadest measure of US trade with the rest of the world - widened to US$195.1 billion (HK$1.52 trillion), or 6.4 percent of GDP, in the first quarter of this year, according to the latest US Commerce Department data published Friday.

``Let's not forget that foreign exchange traders today are focusing more on the other two factors, economic growth and interest rate differentials instead of the current account deficit,'' said JPMorgan's Chan.

But ``like the weather, this could change at any moment.''

REUTERS