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Friday December 14, 2007 - 15:36:49 GMT
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FX Briefing - ECB talks tough, Fed introduces TAF

FX Briefing 14 December 2007


*FOMC cuts central bank rate by 25 basis points

*Fed to ease money market tension with a longer-term repo (TAF)

*USD firms after robust retail sales and high inflation data

ECB talks tough, Fed introduces TAF
EUR-USD was relatively firm up until Thursday, trading between 1.4650 and 1.4750. This was
partly due to comments made by ECB council members, which seemed to confirm that at least some members were in favour of a more restrictive monetary policy. The
US central bank played an important role too.

Beforehand, many market participants had been hoping for a big interest rate cut, and there were rumours that additional measures might be taken to ease money market strains, e.g. by further reducing the spread between the Fed funds rate and the discount rate. But when the Fed decided to cut rates by 25 points only, markets were very disappointed initially; risk appetite evaporated, the Dow lost 2.5%, and the yen rebounded against most other currencies. That evening, USD-JPY fell from just under 112 to 110.50, EUR-JPY from just under 164.50 to 162. As previously in similar situations, the dollar firmed against most other currencies. EUR-USD fell by over half a cent to 1.4650.

However, the following morning things began to ease again, particularly after speculation in the press that the US central bank could perhaps have something else up its sleeve. Sure enough, on Tuesday afternoon, central banks in the major currency areas unveiled a coordinated effort to increase liquidity on a longer term basis. The measures are centred on a new term auction facility (TAF) introduced by the Fed. Similar to the ECB, with its longer-term refinancing transactions,

the Fed will now also offer banks additional liquidity in repo operations, initially for one month. Two auctions before Christmas are to inject up to $40bn into the market; two further auctions are planned for January. Parallel to the Fed’s pre-Christmas auctions, the ECB and the SNB (acting in a way as the Fed’s agents) will offer their counterparts in the money market dollar liquidity of up to $23bn against the usual collateral in those markets. Against this backdrop, foreign exchange swap lines have been established between the ECB, SNB and the Fed.

These actions are aimed at easing the extreme stress in the money markets, particularly in the US. It should be borne in mind that the interbank rates are far higher than the discount rate, for despite the cost advantage and a wider range of eligible collateral, US banks avoid the discount window like the plague. However, at $40bn, the volume of cash to be injected into the market at the December auctions is relatively modest, and the term of about one month is rather on the short side compared to demand. One should therefore not expect miracles. But if the new instrument were accepted and the year-end were to pass smoothly without further calamities, this in itself would be an achievement for the Fed. The international dimension of the activities is important insofar as many European financial institutions are experiencing problems refinancing in dollars, because the asset backed commercial paper market has virtually dried up.

After the Fed’s secret was out, the dollar started off cautiously as from Thursday, but then rallied. One reason for the dollar’s strength could have nbeen the fact that the Fed’s measures are focused specifically on the money market. If they prove successful, the Fed funds rate might not have to be cut so drastically. The economic data released on Thursday could also have played a part: excluding sales at gasoline stations, which were inflated by price increases, US retail sales rose by 0.6% month-on-month in November. In this environment, the worst fears for US consumption in Q4 are not likely to come true. Furthermore, in November, producer prices rose markedly by 3.2% month-on-month, and there was even an 0.4% increase in the core rate, which gives more weight to the Fed’s warnings about inflation risks.

It should be acknowledged, however, that Fed funds futures, for example, are not indicating a marked increase in interest rate expectations either. Thus the arguments are somewhat flimsy. But the weak Tankan presumably also supported USD-JPY, which rose to 112.8 at the end of the week. The Bank of Japan’s business survey shows that sentiment deteriorated sharply in the fourth quarter, both in the manufacturing sector (from 23 to 19) and in other sectors (from 20 to 16). However, it should be pointed out here that the indicators contradict each other, as available Japanese Q4 data on production, exports and private household spending are not that bad up to now.

Despite its current advances, we see little chance of the dollar making a sustained recovery at present. The credit crisis will remain the predominant topic in financial markets for some time to come, and the US are at the centre of this crisis.

Stephan Rieke +49 69 718-4114
We wish all our readers a Merry Christmas and
a happy and successful New Year!

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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