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Friday October 21, 2005 - 16:38:33 GMT
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FX Briefing 21 October 2005

• Dollar’s big interest rate advantage leads to sustained inflows, especially from Japan
• US GDP growth in Q3 remains robust despite burdens

Dollar remains well supported

Towards the middle of the week, USD-JPY climbed to 115.98 – a new two year high. Thus the Japanese currency tentatively dipped into the band of the years 2001 to 2003. During that time, the 115 mark was regarded as the Japanese monetary authorities’ “last bulwark”. The line of defence fell in September 2003, after the G7 had announced in Dubai that they wanted to promote a smooth adjustment of international imbalances, based on market mechanisms. At that time this was seen as the end of the American “strong dollar policy” and as Japan giving way to pressure from America. Therefore from a historical point of view, the most recent USD-JPY appreciation over 115 is quite significant. EUR-USD development was less spectacular, but here too the stable tendency of the dollar remained unchanged – the euro’s interim 15-week low of USD1.1875 illustrating the trend. However, the downward movement is gentle. Towards the end of the week, the common currency actually rose slightly higher than the previous week to just over USD 1.20.

The main argument in favour of the dollar is still the interest rate spread. Due to the Fed’s hawkish stance, the yield of 2-year Treasury Notes has now risen to 4.24%. Thus, compared with similar Japanese government bonds, almost 400 basis points more can be earned, which is obviously a great attraction, particularly to Japanese investors. Japanese statistics on securities transactions confirm this. On average in the four weeks up to 14 October around JPY800bn net flowed into foreign bonds and a further almost JPY200bn into foreign money market paper. On the other hand, the flow into the stock market sank to JPY172bn – no longer a real counterbalance.

At just over 170 points, the interest rate advantage of the 2-year Treasury Note over the Bund is far less blatant. Moreover, in view of the ECB’s “increased vigilance”, the short end of the euro area yield curve tends to be weaker than the Japanese one. This is because markets expect Japan’s shift away from its zero-interest rate policy to take place later and be smoother than the ECB’s policy change. The ECB has started using pretty clear words to prepare the markets for possible interest rate hikes. Most recently, the ECB’s chief economist Otmar Issing said that the central bank would act if it saw medium-term inflation threatening to run out of control and that one could not forever just react with threats and interpretations. The ECB’s more aggressive stance is likely to be the main reason why the euro is somewhat more robust on the forex markets than the yen.

However, the movement is not exactly dynamic. The central banks’ open mouth policy, which significantly helped the markets to find their footing after the hurricanes, is not offering anything new. Now we will have to see how the situation actually develops compared to the assumptions of the central banks.

The conservative policy could prove to be right for the US. Both consumer and producer prices accelerated massively in September to rates of 4.7% and 6.9% respectively. Although the core rates are still relatively moderate at 2.0% and 2.6% respectively, the huge difference between the headline rate and the core rate shows how much price pressure there is in the system. It would be naive to assume that such a strong impulse (mainly from energy prices) would just vanish into thin air without any knock-on effects. The Beige Book is already registering first signs of price increases being passed on. Moreover, the prices received component of the Philly Fed index, which measures companies’ expectations about the prices they will receive for their products, has risen to the highest level since 1988.

So the warning signals on the price side are hard to overlook even if most energy prices have retreated somewhat. The question is now whether growth will really weaken only temporarily and moderately, as the Fed assumes. There is some encouraging data, such as the Philly Fed index. It will be interesting to see next week whether consumer confidence (Conference Board) is showing signs of recovery. While the University of Michigan index dropped a little further in October, the weekly ABC poll has been perking up since the end of September. The labour market situation seems to be relatively robust too. Thus on the whole, things are looking favourable for the Conference Board indicator.

Also at the end of the week the first estimate for GDP growth in the third quarter will be released. On the basis of the data already available on production and consumption expenditure, we are confident that growth will be similar to that in the second quarter (3.3% qoq), possibly even exceeding it. The immediate macroeconomic damages caused by the hurricanes would thus be on a manageable scale. Given also that the energy prices have fallen (WTI crude oil is at present trading at just under USD60 per barrel), the data would fit into in the Fed’s growth scenario. The dollar would thus remain well supported.

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.
© 2005 BHF-BANK Aktiengesellschaft
All rights reserved. Please mention source when quoting from it.


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