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FX Briefing - ECB clears the way for interest rate cuts

FX Briefing 8 February 2008



* Dollar strengthens despite very weak economic data

* BoE cuts bank rate by 25 bp to 5.25%, referring to financial market problems

* ECB reveals growth concerns


ECB clears the way for interest rate cuts

The US labour market report shows that payrolls fell by 17k in January; at the same time employment levels were adjusted significantly downwards in the government’s annual revision. House price indices such as the RPX Composite and pending home sales indicate that the downward trend in the housing market is set to continue. The ISM non-manufacturing index, which primarily covers the services sector, plummeted from 54.4 to 41.9 in January. This is the lowest level by far for years: the only month it has been lower in its 10-year history was straight after the 9/11 attacks. The ABC index, a weekly consumer confidence indicator, plunged to –33 at the beginning of February, which is the lowest it has been since autumn 1993.

All this has had little impact on the dollar, however: it has strengthened across the board. During the course of the week, USD-JPY only rose slightly to about 107.50, but EUR-USD dropped almost 3% to below 1.45. This movement was triggered mainly by the ECB hinting for the first time that it might cut interest rates. In the wake of the euro, the other European currencies fell too. The Swiss franc held its ground relatively well, and so did the pound sterling, in spite of the Bank of England’s 25 basis point interest rate cut to 5.25%. The Swiss franc seems to have overcome its weakness: at around 1.60, EUR-CHF is now about 6 rappen lower than at the beginning of the year. The relative strength of the pound is probably due to the fact that an interest rate cut of this size had been widely expected; and with

EUR-GBP around 0.7430, the pound has only gained 1.5 pence since its all-time low of mid- January. Some emerging market currencies were hit hardest, particularly the rand and the forint, indicating that investors are becoming more cautious: the currencies of countries with problems such as high current account deficits, political uncertainty or high inflation are increasingly being left by the wayside. High money market rates alone are no longer enough to make a currency attractive. It looks as though, as expected, the ECB is about to change track: in its comments over the past months, the ECB governing council had always emphasized the inflation risks and consequently dismissed any possibility of interest rate cuts. In its statement on Thursday, the council is now admitting that there is “unusually high uncertainty” about the economic outlook. The deterioration in the international environment (i.e. USA,

UK) is likely to have an impact; while the economic fundamentals of the euro area are sound, European data are indicating that growth is slowing down. Moreover, the ECB sees the risk of the financial market crisis having a negative effect on financing conditions and economic sentiment and thus also on euro area and global growth. ECB president Jean-Claude Trichet also confirmed that, as expected, the ECB council would be revising its growth projections for 2008 down in March. The ECB continues to see upside risks to price stability. But if inflation rates go down in the next few months, as they are expected to do, and the economic slowdown in the euro area becomes more evident, the ECB is not likely to delay interest rate cuts any longer. In our view, the adjustment process in the financial system will take some time yet, and economic activity in the euro area too will be dampened over a longer period. Consequently, we are expecting monetary policy to loosen significantly. The refi rate could fall to 3.5% by as early as mid-year, and further steps are likely to follow.

A certain US optimism seems to be influencing exchange rate developments at the moment: the US are sliding into a recession, but economic policy has reacted swiftly and decisively. Thu the markets are hoping that there will soon be light at the end of the tunnel. Against this backdrop, it is easier to understand why the “extremely downbeat” data from the US had so little impact on the forex market.

Since EUR-USD dropped significantly last week, there is some consolidation potential. It is also feasible that the ECB council hawks could try to dampen market participants’ expectations of an early interest rate cut somewhat. On the other hand, fundamental data, next week mainly from Europe, could weaken EUR-USD even more: EMU countries’ GDP figures are likely to confirm the economic slowdown, and after the setbacks on the equity market, the ZEW index will presumably plummet even further. The G7 meeting of finance ministers and central bank governors in Tokyo is unlikely to deliver any new message on currencies. What could be interesting is whether, and to what extent, the G7 partners  seem willing to take expansive monetary and fiscal policy action. Because this would in effect  be about interest rate cuts in the EMU.

Stephan Rieke +49 69 718-4114

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.

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