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Friday January 25, 2008 - 16:29:57 GMT
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FX Briefing - Fed takes emergency action after stocks crash

FX Briefing 25 January 2008



􀂾 Recession fears (and possibly SocGen sales) cause stocks to plummet

􀂾 Fed cuts interest rate by 75bp, further step likely on Tuesday

􀂾 ECB refuses to cut interest rates for the time being, but growth risks are increasing


Fed takes emergency action after stocks crash

The stock market crash was the dominant theme on the financial markets this week. On Daikan, the coldest day of the year according to the Japanese calendar, Asian stocks were the first to plunge, followed by European shares. At its lowest point on Wednesday, the German DAX had lost nearly 13% compared to the closing prices the previous Friday, and the EuroStoxx 50 just under 12%. The Nikkei index fell over 9%, the Hang Seng almost 14%. The crash was caused by market participants’ uncertainty as to the consequences of the housing market and credit crisis primarily for the US, but also for the rest of the world. On Thursday, it emerged that Société Générale’s fire sale of the long positions amassed by a rogue trader after the fraud came to light (with losses amounting to almost €5bn), could possibly have contributed to the stock market crash.


Thanks to the public holiday on Monday, the US markets were not affected by the crisis at first. Then on Tuesday, there were rumours that the Fed was about to make an emergency interest rate cut. And sure enough, shortly before the start of trading in America, the US central bank announced a 75 basis point cut in the Fed funds rate to 3.5%. The Fed’s action probably prevented a bigger slide in US stocks: the Dow Jones only lost about 4% at most, which was relatively moderate. However, at first equity markets were uncertain as to whether they could really bank on the Fed’s support. On Wednesday, shares plunged again before starting to recover significantly during late US trading. On Thursday and Friday, Asian and European markets picked up again too.


Last year equity market volatility peaks always seemed to go hand in hand with a sharp increase in yen volatility and the yen gaining against practically all currencies. This pattern reflects in the unwinding of risk positions on the forex market, particularly carry trades. Usually during these phases, the dollar has strengthened against other currencies, particularly against the euro, partly because the dollar is not often used as a carry currency, and partly because, when risk aversion increases, dollar-orientated investors tend to go back to the dollar as their home or base currency. This reaction pattern was evident last week too. Whereas USD-JPY fell from around 107 towards the end of the previous week to a low of 105, EUR-JPY dropped about 5 JPY to just over 152. When equity markets started calming down again, the movement reversed, and USD-JPY rose to about 107.50, and EUR-JPY to around 158.50. EUR-USD dropped from 1.4650 at the end of last week to below 1.44 on Wednesday, only to recover again to over 1.47 in the latter half of the week.


Contrary to the European equity markets, the euro will probably have gained slightly againstthe dollar and the yen at the end of the week. Once again, monetary policy is the main reason for this development. The US central bank’s latest interest rate step has made it quite clear that stabilising economic growth is its top priority. In its statement last Tuesday the Fed said that “appreciable downside risks to growth remain”, thus indicating the future path of monetary policy. The Fed also promised that it would “act in a timely manner”.


Against this backdrop, market expectations that the FOMC will cut interest rates again at its regular meeting next Tuesday, are quite plausible. Bearing in mind that in the past months, the Fed has always been keen to stay ahead of the curve, we think it possible that the Fed funds rate will be cut again to 3%.


In contrast, the ECB is signalling that due to inflation risks, interest rate cuts are not on the agenda for the time being. ECB president Jean-Claude Trichet, ECB board member Jürgen Stark and Bundesbank president Axel Weber all confirmed that growth in the eurozone is basically robust. Some recent economic data support this view. Neither the ifo business climate index nor the consumer climate index showed any sign of weakening further. French business confidence also remained stable in January.


Last week we pointed out that ECB representatives’ tone was becoming a little more dovish. We are still sticking to this view. The most recent comments also show that, in the ECB’s view, growth risks are now higher than they were a few weeks ago. We are therefore expecting the ECB governing council to make its monetary policy position somewhat more “open” or more “flexible” at the beginning of February. The fact that the oil price has gone down to about $90 will give the council a bit more scope to do so. The Fed’s interest rate cuts have greatly increased the euro’s interest rate advantage.


Whereas the ECB is holding back, further monetary policy loosening is on the cards in the US, both in the short term, i.e. at the next meeting, and in the longer term. In this environment, the dollar is not likely to make a sustained recovery, particularly as the economic risks originated and are centred in the US. The numerous US economic indicators due to be released next week, including Q4 GDP, the ISM index and the January labour market report, are more likely to weigh on the dollar.


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 "BHFBANK 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. This document is published by us in German and English only. Publications in other languages have not been authorised by us.

© 2008 BHF-BANK Aktiengesellschaft

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