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FX Briefing - Beyond 1.60 the ice gets thin

FX Briefing 25 April 2008


·        Weak ifo dampens growth optimism

·        Markets are speculating on US rate cut cycle coming to an end

Beyond 1.60 the ice gets thin

After EUR-USD had passed 1.59 for the first time in mid-March, it was just a matter of time before it hit 1.60. In the last fortnight, the European currency has been inching nearer and nearer to that level, and on Tuesday, it finally managed to breach 1.60 for the first time, briefly hitting a high of 1.6020. But the ice gets thin beyond 1.60: subsequently, the single currency plummeted to below 1.56.

 Exchange rates are still being driven by interest rate expectations for the eurozone on the one hand and for the US on the other. The fact that 2- year government bonds, for example, have dropped significantly shows that interest rate cut expectations have been priced out, both for the eurozone and for the US. During the last few months, doom and gloom had prevailed in the US, but now some people are starting to voice the opinion that the crisis might have bottomed out. Some Fed representatives have even made cautious references to inflation risks and indicated that the interest rate cut cycle might be coming to an end.

In Europe, market participants have begun to price out the interest rate cuts which had up to now been expected for the second half of the year. This is mainly because inflation has accelerated. Even if food prices slowly stop rising and energy prices stabilize, the inflation rate will still not fall much below 3% this year. Unless one is banking on falling energy prices, the price situation is not likely to ease more significantly until well into 2009.

Because of the prospect of higher inflation rates persisting for somewhat longer, the ECB will probably refrain from cutting interest rates for the time being. This is even more likely to be the case as long as macroeconomic demand remains robust, thus fuelling inflation. Growth prospects, however, were dealt a hefty blow this week: the latest European business climate indicators showed a marked deterioration in April. The German ifo business climate index fell by more than 2 points to 102.4; and companies’ assessment of the business situation, which had been stable up to now, deteriorated particularly. This trend is also evident in France, the Netherlands and Belgium.

 The weaker economic indicators in the eurozone were not enough to revive hopes of interest rate cuts in the near future. However, they mitigated the impact from the US, where yields began to increase substantially on Thursday afternoon; yields on 2-year US Treasuries rose from 2.20 to 2.46%, and from 3.72 to 3.90% on T-notes. The economic indicators published on Thursday afternoon are unlikely to have triggered the interest rate movement in the US. The new home sales figures were disastrous: taking February and March together, sales have plummeted again by over 13% to a level last seen during the severe recessions of 1980/81 and 1990/91. Durable goods orders fell for the third time in a row. The fact that durable goods orders ex transportation increased by 1.5% is no consolation either, particularly as the steep drop in transport goods is not so much due to volatile aircraft orders, but rather to demand for automobiles plunging further.

 The only more or less positive data were the decline in initial jobless claims by 33,000. Whether, however, one single week’s figures, which might be distorted by seasonal adjustment factors, can be regarded as a reliable sign that the employment market is improving, is doubtful to say the least. Presumably, the figures served more as a catalyst rather than a trigger for the subsequent substantial correction on the US bond market. The actual reason was probably the impending FOMC meeting. Recent remarks made by Fed representatives have reinforced expectations that the US central bank could take one final interest rate step next week and then change to a more neutral stance. The argument is that the Fed funds rate has now reached a very low level, particularly taking accelerating inflation and the expansive effects of the weak dollar into account.

 Signs of an economic slowdown in the eurozone and the possible end of the Fed’s monetary policy easing have led to the interest rate spread between the EMU and the US narrowing  by 25 points on 2-year bonds to just over 140 basis points at present. Simultaneously, the dollar firmed noticeably.

 In our view, however, the downswing in the US has by no means bottomed out yet. The numerous US economic indicators due to be published next week, could well dim hopes that a cyclical turning point has been reached. The Fed is also likely to take care not to play down the risks posed by the credit and housing market crises prematurely, thus making the yield curve even steeper at the long end. We are therefore only expecting minor modifications to the statement.

Next week’s European data are not likely to alter the overall picture much. The rise in consumer prices could have declined slightly in the EMU, and somewhat more in Germany, but a turnaround is not yet in sight. Other economic indicators are likely to paint a mixed picture: the consumer climate in Germany could have improved, whereas the number of unemployed will have gone up again for the first time.

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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