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Forex Blog -FX Briefing - ECB signals interest rate rise in July

FX Briefing 6 June 2008

·        Highlights

·        Bernanke warns of inflation risks, stresses importance of strong dollar

·        ECB staff revise inflation forecasts significantly upwards

·        ECB in a state of heightened alertness

·        Hawkish ECB strengthens euro, limits dollar’s upward potential

ECB signals interest rate rise in July
Up until Thursday afternoon, the main focus was on the dollar. EUR-USD firmed to below 1.54 temporarily. This was mainly due to remarks made by Fed chairman Ben Bernanke on the subject of exchange rates; he said that the weak dollar had contributed to the sharp increase in import and consumer prices, and that the Fed would be monitoring exchange rate developments very carefully.

Mr Bernanke’s remarks on the dollar are particularly striking because the Fed very rarely comments on the foreign exchange market – partly because the Treasury is responsible for currency policy, and partly because politics’ influence on foreign exchange markets is very limited and difficult to predict. Mr Bernanke’s remarks suggest that US policymakers have agreed that the dollar should not be allowed to depreciate further. The statement was presumably also coordinated internationally, as on 13 and 14 June, the G8 finance ministers are meeting in Osaka.

There are three main reasons as to why the US administration has deviated from its policy of benign neglect as regards dollar weakness: (1) The fact that the dollar is undervalued is boosting exports significantly; discounting the oil price effect, the foreign trade deficit has already declined markedly. (2) Crude oil price and dollar exchange rate are now closely correlated; presumably dollar depreciation is pushing up the prices of crude oil and other commodities. (3) The USA’s substantial financing needs, particularly the need for fresh capital for the banking system, cannot be met without foreign investment; but with low interest rates and a weak currency, there is little incentive for foreign investors to invest in the US.

There was a big surprise at the ECB press conference on Thursday: President Jean-Claude Trichet announced that the Governing Council was in a state of heightened alertness. In reply to journalists’ questions, he even said that a decision to raise interest rates could be taken in July: this was “possible, but not certain”. In the new ECB staff projections, the inflation forecasts were revised up substantially from 2.9 to 3.4% for 2008 and from 2.1 to 2.4% for 2009 (all figures middle of the range), which underlined the more hawkish position.

Possibly, when formulating its policy stance, the ECB Council had had a gradual tightening of monetary policy in mind in order to show its determination to act when necessary and maintain its credibility. Jean-Claude Trichet emphasized that the decision to raise interest rates was not yet certain and indicated that the interest rate step would only be a small one. Nevertheless, his remarks caused a strong market reaction: market participants are now pricing in almost three interest rate increases within the next six months. The yield on 2-year Bunds shot up by more than 30 points to 4.65% (briefly peaking at 4.78%), the interest rate spread between 2-year Bunds and 2- year T-notes widened nearly as much to about 210 basis points (peaking at 228 bp). At the same time, the euro strengthened by more than two cents to 1.56. The dollar’s gains after Ben Bernanke’s speech turned into a slight loss.

It remains to be seen whether a rate tightening cycle is really on the agenda. In our view, which is compatible with the ECB projection, inflation will peak in Q3 and go down to about 3% in Q4. From the second quarter on, economic growth is likely to slow down significantly. The ECB itself has again indicated that there is a downward risk to growth, and its staff is forecasting growth of 1.8% in 2008. This looks quite good at first glance, but, because of the overhang in Q1, would in fact mean little more than stagnation in the second to the fourth quarter (0.2% per quarter). The financial markets situation has not eased much either. The interbank market and asset backed securities markets are still not functioning normally, banks’ earnings are weak for the most part, and are likely to be additionally burdened by interest rate hikes; furthermore, capital constraints are hampering banks.

In our view, the macroeconomic situation still does not warrant raising interest rates. However, the ECB Governing Council has now apparently made up its mind to take this step. Once this decision has been taken, it will be difficult to reverse it; the hurdles for a subsequent interest rate cut get higher, and those for raising interest rates further lower. At the moment, it does not look as though anything could stop interest rates being raised in July as signalled.

In view of all this, it is likely to be difficult for the dollar to gain ground in the near future. Although the Fed, and possibly the G8 summit too, will probably support the US currency, the upward potential appears to be limited. In the next few weeks, there are likely to be numerous comments from ECB representatives underlining the ECB’s hawkish stance. Weaker economic data, such as the German industrial new orders and production output figures just released, are unlikely to have much of an impact.

Stephan Rieke +49 69 718-4114

Economics Department
+49 69 718-3642
volkswirtschaft@bhf-bank.com
Foreign Exchange Trading
devisenhandel@bhf-bank.com
Jörg Isselmann
+49 69 718-2695
Matthias Grabbe / Klaus Näfken
+49 69 718-2688

 

<i>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.

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