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FX Briefing - Further upward potential for the euro is limited

FX Briefing 28 Mär 2008


·        Dollar hits new lows following Bear Stearns crisis

·        Hawkish ECB and higher ifo push interest rates up, EUR-USD remains firm

·        Interest rate increase overdone given risks to financial system and growth

Further upward potential for the euro is limited

The financial market crisis escalated again at the beginning of the Easter week when Bear Stearns had to be rescued. Equity markets suffered heavy losses and credit spreads widened again substantially, pushing the US dollar down to new lows. USD-JPY plummeted, hitting a trough of below 96; levels last seen for a few months in 1995. EUR-USD made significant gains and rose over 1.59 for a short time.

Since then, the dollar has managed to regain some ground, particularly against the yen: during
the last 9 trading days, the exchange rate has been hovering around 100. The dollar was probably boosted by the fact that equity markets, andin particular financials strengthened slightly, following the quarterly reports of Lehmann, Goldman Sachs and Morgan Stanley. The dollar’s rebound could also have been triggered to some extent by profit-taking before the long Easter weekend. One of the main reasons, however, was probably the Fed’s decision “only” to cut the Fed funds rate by the amount originally expected (still 75 basis points) to 2.25%, and to combat the liquidity problem in the money marketby other means.

At first the dollar had made a significant recovery against the euro too. Shortly before the holiday weekend, EUR-USD had gone up to around 1.54 again. On the night of Easter Monday, however, the market turned round again. The euro firmed to about 1.58. And it looks as though the single currency will close the week at this level – just below the peak – too.

A spate of divergent macroeconomic data from the EMU and the US is one reason for the sustained strength of the euro. US consumer confidence plummeted again in March from 76.4 to 64.5. The Case-Shiller home price index shows sustained declines in house prices; in January, prices were almost 11% lower than a year earlier. In February, new homes sales dropped to 590,000. Sales figures have only been lower in February 1995 and during the 1990/91 recession. What is more, durable goods orders also declined markedly again by 1.7% in February, indicating, amongst other things, weak investment in machinery and equipment.

Contrary to the paltry figures from the US, European business climate data were unexpectedly positive. The German ifo business climate index improved for the third consecutive month. The manufacturing, wholesale and construction industries all recorded increases, and retail sales, which had soared in February, held up quite well. But not only the German figures were favourable; upbeat data also came from from France and Belgium. Furthermore, accelerating inflation in Germany indicates that EMU inflation could possibly rise again in March.
ECB president Jean-Claude Trichet took the same line in testimony to the European Parliament’s Committee on Economic and Monetary Affairs, emphasizing the ECB’s commitment to contain inflationary pressures. According to Mr Trichet’s comments, all that is required from the ECB at the moment is to ensure that banks get the necessary liquidity (i.e. by making central bank funds available at the refi rate). But Mr Trichet did not show any willingness to ease the constraints in the financial sector, or to ward off spillover effects into other economic sectors, by cutting interest rates.

Against a backdrop of hawkish comments from the ECB, improved economic data and higher
inflation rates, interest rate cut expectations have been priced out for the euro area. Going by Eonia swaps, markets have reduced their rate cut expectations by around 35 basis points to about 40 basis points (within the next 9 months) compared to the first half of March. Deposit rates rose even more sharply, mainly because risk premiums have been pushed up further due to the financial market turmoil and the impending end of the quarter. During the course of March, Euribor rates in all maturity segments from
3 to 12 months rose by over 35 points to well over 4.70%.

In our view interest rate increases in the euro area are exaggerated. It is right that macroeconomic data and ECB comments are making interest rate cuts unlikely for the time being. However, we do not see any signs suggesting that the outlook for the euro area has fundamentally improved. On the contrary, the global economic environment and the situation in the financial markets appear much more serious today than a month ago. The signs that the US is in a recession are increasing. Moreover, the constraints in the financial system have got worse. A month ago, no-one could have envisaged an institution like Bear Stearns packing up completely.

The latest European economic indicators are remarkably robust, but things could change quickly. The production figures show a sharp increase in output, whereas new orders have been levelling off since last autumn. The ifo’s strength is based solely on assessments of the current situation. By contrast, business expectations are now predominantly negative. Rising energy prices and the appreciation of the euro are additional burdens.

In this environment, we see very little upward potential for EUR-USD from its present level. In the short term, however, the situation is uncertain: next week’s economic data will probably confirm the impression of divergent macroeconomic developments in the US and the eurozone, but are not likely to have a significant impact on the markets after last week’s substantial interest and exchange rate adjustments.

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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