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Friday December 7, 2007 - 15:32:47 GMT
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FX Briefing - ECB: interest rate rise not out of the question

FX Briefing 7 December 2007


·        BoE and BoC cut interest rates; Sterling and Canadian dollar fall

·        ECB emphasises risks to price stability and warns of second-round effects

·        Money markets grow more tense towards the end of the year

ECB: interest rate rise not out of the question
During the last few days, the dollar continued to gain ground. The euro lost around 1 cent against the dollar, falling to about 1.463; EUR-USD had even approached 1.45 temporarily, but ECB president Jean-Claude Trichet’s remark that some ECB board members were in favour of tighter interest rates, supported the euro. The dollar only rose slightly against the yen, from 110.70 to about 111.50. The US currency made relatively substantial gains against the pound Sterling and the Canadian and Australian dollars. The central banks were responsible for this: the Bank of England and the Bank of Canada both cut interest rates by 25 basis points respectively, and the Reserve Bank of Australia hinted that no further interest rate hikes were planned for the time being. In contrast, some emerging market currencies, including the rand, the Turkish lira and the real, strengthened against the US dollar, as did the New Zealand dollar on the NZ central bank’s hawkish statement.

The firming dollar is pretty much in line with developments in the US equity market, which remained in good shape, after having rebounded sharply last week. US economic data were not all that bad either: in November, the ISM manufacturing index remained above the expansion threshold at 50.8, the ISM non-manufacturing index slipped slightly from 55.8 to 54.1 – albeit still quite a high level. On the whole, the ISM indices are indicating a downward trend, but up to now there is no evidence of a sharp slump. Due to an increase in consumer goods orders, total factory orders actually rose somewhat in October. But the ADP indicator really stole the show: contrary to almost all other employment indicators, it showed an increase of 189,000 jobs in the private sector in November, thus to some extent assuaging fears of the labour market report. The US government also contributed to the more favourable mood by unveiling a plan to avoid forced home sales. According to the agreement, loan rates on some variable rate mortgages can be frozen for five years; furthermore, borrowers who are basically able to afford their mortgages, are to be offered refinancing by the Federal Housing Administration.

However, these positive factors contrasted sharply with the development in the money market, where signs of distress have been increasing. Futures contracts are pricing in Fed interest rate cuts of at least 25 basis points, possibly even as much as 50, for next week. Furthermore, the Fed funds rate is expected to fall to 3.25% by the end of 2008. Interest rate cut expectations of 125 basis points are bold in themselves, especially as the Fed had still until recently been hesitant to cut rates further. But, despite the aggressive interest rate cut expectations, conditions in the money market are extremely tight. In the last few days, USD three-month money rates have been over 5.50%. And, although US interest rates are expected to have fallen to 3.25% in a year’s time, rates of over 5.20% are still being paid for 12- months deposits. At the moment, the liquidity premium is roughly 150 basis points.

Trichet hints at interest rate hikes
Whereas in November, ECB president Jean- Claude Trichet seemed to be playing down inflation risks somewhat, referring to an “inflation hump”, last Thursday he took a pretty hawkish stance. As in the previous months, he confirmed the bank’s assessment that there are upside risks to price stability over the medium term. With regard to the current situation, he spoke of strong upward pressure. He warned of increasing wage pressure and companies price-setting power, and stressed that the ECB would ensure that second round effects did not materialise. What was particularly striking was his comment that the ECB Council had discussed raising interest rates (butnot cutting them), and that “some” members had been in favour of a rate rise.

This unusual insight into the inner workings of the ECB Council should be taken as a warning to the markets. In the last few weeks, the markets had increasingly disregarded the ECB’s remarks about risks to price stability and begun to price in interest rate cuts. Now the ECB has made it clear, that in the present circumstances, a rate rise is still more likely than a rate cut. The latter would probably only be considered if the credit crisis were to cause a significant growth slowdown, and if inflation cooled down noticeably.

The ECB is emphasising that interest rate hikes in the euro area are by no means off the agenda. The situation is thus quite different from the US, where the Fed is set to cut rates next Tuesday. This should theoretically support the euro. However, the markets have already priced in very aggressive interest rate cuts by the Fed, and this makes things more complicated. There is thus some potential for disappointment here. However, we are expecting the Fed to indicate scope for further steps, which would balance things out to some extent.

Stephan Rieke +49 69 718-4114

Economics Department
+49 69 718-3642
[email protected]
Foreign Exchange Trading
[email protected]
Jörg Isselmann
+49 69 718-2695
Matthias Grabbe / Klaus Näfken
+49 69 718-2688


This report has been prepared by BHF-BANK Aktiengesellschaft on behalf of itself and its affiliated companies (together "BHF-BANK Group") solely for the information of its clients. The information and opinions in this document are based on sources believed to be reliable and acting in good faith, but no representation or warranty, express or implied, is made by any member of the BHF-BANK Group as to their accuracy, completeness or correctness. Opinions and recommendations are given in good faith but without legal responsibility and are subject to change without notice. The information does not constitute advice or personal recommendation, for which the duty of suitability would be owed, but may facilitate your own investment decision. Moreover, you should seek your own advice as to the suitability of an investment matter mentioned herein. Investors are reminded that the price of securities and the income from them can go down as well as up and that the past performance of an investment or a market is not necessarily indicative for future results. This document is for information purposes only. Descriptions of any company or companies or their securities mentioned herein are not intended to be complete, and this document is not, and should not be construed as, an offer to sell or solicitation of any offer to buy the securities mentioned in it. BHF-BANK Group and its officers and employees may have a long or short position or engage in transactions in any of the securities mentioned in this document, or in any related securities. This publication must not be distributed in the United States.

© 2007 BHF-BANK Aktiengesellschaft

All rights reserved. Please mention source when quoting from it.



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