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Saturday October 8, 2005 - 11:57:27 GMT
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FX Briefing 7 October 2005

Highlights
* ECB hints out growing inflation risks but takes no action yet
* Rising inflation gives BoE less leeway for further interest rate cut

ECB takes tougher line


Under the impact of repeated hawkish comments by Fed representatives and some strong economic data, EUR-USD slipped initially to USD1.1900, whereas USD-JPY increased to a peak of JPY114.41. The dollar’s gains only lasted until the middle of the week. Then the yen and later the euro too started to gain ground. The weakening of the dollar was due to the markets’ becoming
less affected by Fed talk, the weaker ISM non-manufacturing index and general nervosity before the release of the US employment market report for September.

This trend was strengthened by the ECB taking a tougher line. At the press conference after the ECB Council’s meeting, Trichet commented that the central bank still considered the interest rate appropriate, but that strong vigilance with regard to upside risks to price stability was warranted. A raise of the refinancing rate before the end of the year is now being considered feasible. Towards the end of the week, EUR-USD rose considerably to around USD1.2150. USD-JPY slipped to 113 for a short time but recovered on Friday to almost JPY113.50. EUR-JPY remained firm and increased during the course of the week from JPY136 to around 138.

The comments of ECB president Trichet have confirmed our expectations that the central bank interest rates in the EMU will be raised in the first quarter at the latest. In our view, there are
two conditions for this scenario: Firstly, it is based on the assumption that energy prices will remain at the current high level. If energy costs sink, the situation would ease up considerably. Secondly, the ECB’s favourable growth expectations for the second half of the year – with growth rates of about 0.5% per quarter – would have to prove true. If however, second round
effects appear in prices or a significant increase in inflation expectations becomes evident, the ECB will probably act irrespective of growth figures. The benchmark could be the development of core inflation and wage costs as well as price expectations surveys and the yields of inflation- indexed bonds.

We also consider it possible that interest rates will be raised in December. The attraction of this date is that the ECB’s projections will have been brought up-to-date in December. If September’s growth projections and the upwards revision of inflation projections are confirmed, important prerequisites for an interest-rate hike will have been fulfilled.

BoE: Hardly any leeway for interest rate cuts
The euro has also strengthened against the British pound. Given muted consumer demand and weak industrial production, most London players are reckoning with a further cut in the central bank interest rate to 4.25%. We would advise caution here, however: even if the growth rate in Britain has slowed down significantly and has developed below the average of the previous years, the
growth rate of 0.5% qoq in Q2 and probably a similar increase in Q3 cannot really be described as weak. Also the house price development indicators, which were recently regarded as a growth risk, are now more favourable again. Whereas the Nationwide house price index displays a rather flat development, the Halifax index has been showing significant increases for the last few
months.

At the same time the inflation rate will probably rise from 2.4% in August to over 2.5%. We are wondering whether in this situation, an “inflation targeter” like the Bank of England (with its inflation target of 2%) has leeway for an interest rate cut. The BoE would have to place a very strong emphasis on the “economic risks” to justify the necessity of an interest rate cut, especially when, in the light of rising inflation rates, other central banks are stressing the risk of passing on higher energy prices and the danger of increasing inflation expectations. Given this situation, we do not see a tendency towards a weakening of EURGBP.

Stephan Rieke 069 718-4114

Economics Department
+49 69 718-3642
volkswirtschaft@bhf-bank.com
Foreign Exchange Trading
devisenhandel@bhf-bank.com
- 3 -
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.
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© 2005 BHF-BANK Aktiengesellschaft
All rights reserved. Please mention source when quoting from it.

 

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