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Friday February 10, 2006 - 16:25:37 GMT
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FX Briefing 10 February 2006

FX Briefing 10 February 2006
• Signs are increasing that BoJ will change policy in Q2
• Monetary policy uncertainty makes USD-JPY more volatile
• Pace of renminbi appreciation increases ahead of G7 meeting

The dawning of a new era: the end of quantitative easing policy draws closer

At the beginning of the week, the euro continued its downward trend, which had started after the release of US labour market data, but then stabilized within a narrow range of 1.1950 to 1.2000. The few attempts to break out of this tradingrange proved to be short-lived. USD-JPY was much more volatile: the dollar firmed up against the yen initially, parallel to the EUR-USD movement. However, on Tuesday morning, the rate slipped from over 119 to a temporary low of 117.61.

Increasing nervousness
This could have been partly due to reports that a large Japanese insurance company was planning to increase the euro share in its portfolio at the expense of the dollar. However, the main reason was probably market players’ increasing nervousness about the imminent end of the zero interest rate policy, particularly around the Bank of Japan policy board meeting. From Wednesday on, the yen started recovering again. Central bank governor Toshihiko Fukui announced that, starting with the next policy meeting, the assessment of the price development would become more crucial. But this statement did not have a lasting impact either, for USD-JPY climbed to just under 119. On Friday morning however, fear of interest rate hikes gained the upper hand again on the Asian markets, and USD-JPY fell to around 117.70.

The Japanese economy has found its footing: for the third consecutive year the gross domestic product has been growing at or above potential. Fourth quarter GDP growth is expected to have reached 1-1.5% quarter-on-quarter, which would bring the annual growth rate in 2005 to around 2.7%. Even if the economy loses momentum, the statistical overhang from last year will ensure a decent growth rate in 2006 too. The growth impulses are no longer coming from external trade alone; private consumption and business investment in particular are doing well too.

So far the Bank of Japan has stuck to its zero interest rate policy with quantitative targets for (over-)providing the banks with liquidity. The bank had committed itself to continuing with its ultra-loose monetary policy until a clear upward trend in inflation rates had been established. The core rate of Japanese consumer prices (excluding fresh food) has now been positive year-on-year since October. At the beginning of March, January price data will be published. We expect inflation to have picked up to around 0.4% year-on-year and this is the level we will probably be seeing for the rest of the year too.

Because of these developments, the BoJ had already started to pave the way for a monetary policy turnaround last year. It remained rather vague about this, however, especially with respect to a time frame. Central bank governor Fukui spoke of some time in the fiscal year 2006/07, which starts in April. Mr. Fukui was alsointent on curbing interest rate hike expectations. He said that the interest rate level would still be very low after the policy change. With the latest remark that more weight would in future be given to the assessment of the price development, the signs are increasing that the transition to a conventional interest rate orientated monetary policy might commence in spring. A good opportunity for this would be 28 April, when the bi-annual Outlook for Economic Activity and Prices is presented. Just like the Fed and the ECB earlier, the Japanese central bank will want to give the capital markets some indication of its longer-term plans for interest rates. Its monthly report would be one possibility to make its intentions transparent. One argument against starting a new era of monetary policy at the end of April is that virtually the whole of Japan traditionally takes off the following Golden Week with its three national holidays.

To start with, the BoJ will reduce excess liquidity. The target range for the banks’ current account balances with the central bank might, for instance, be cut to 27-32trn yen, which a minority on the board has been voting for for months. The interest rate can only be used as a tool for steering the money market when liquidity matches actual demand. Therefore the BoJ is unlikely to set a positive key interest rate until some time in the second half of the year.

The market has priced in relatively strong interest rate hikes; the money market contract for December is currently implying a 3-month money market rate of around 0.5%. As long as the central bank remains unspecific about its intentions, the uncertainty about the pace and extent of interest rate increases will be relatively high. In this situation, USD-JPY remains prone to correction. Given the huge interest rate differential, the yen is still one of the most attractive currencies to borrow, but the risk of carry trades is increasing as the Japanese economy continues on its path of solid growth and the central bank starts to tighten.

China: Faster renminbi appreciation?
The renminbi’s appreciation since the central parity adjustment last summer has been disappointing. The theoretically possible fluctuation of 0.3% compared to the fixing of the previous day has in no way been used to its full extent. Over more than six months, the renminbi has gained as little as 0.7% against the US dollar. But since the Chinese New Year Festival, it has moved somewhat more strongly (cf. chart). The purpose of this movement might be to take the wind out of G7/G8 critics’ sails this weekend.

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.
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