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Friday February 17, 2006 - 17:24:45 GMT
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FX Briefing 17 February 2006

• Strong growth in Japan brings monetary policy change closer
• Bernanke indicates sustained necessity for further tightening
• Euro is “pig in the middle”

USD or JPY: a tough choice

After the yen’s substantial gains last Friday, there was not much movement this week. The US dollar benefited from the rather hawkish message delivered by the new Fed chairman and the strong economic data and showed quite a firm tendency. EUR-USD fell somewhat to below 1.19. USD-JPY recovered slightly to about 118.50. EUR-JPY is somewhat firmer at just under 141. The losers of the week were the Swedish krona and Norwegian krone and the New Zealand dollar. Reports that interest rate rises could be lower than expected, particularly in view of the very low inflation rates which are currently under 1%, had a negative impact on the Scandinavian currencies. In New Zealand, there are increasing signs that growth is slowing down.

At present, there are two main currents on the forex markets. The first is Japan. Despite a very unfavourable start to the year, the Japanese economy grew by around 2¾% in 2005; in the fourth
quarter, real GDP increased by a further 1.4% quarter-on-quarter and is thus 4.2% higher than the previous year. The figures clearly highlight the fact that Japan is no longer a case for concern. Even if the increase in consumer prices is still only very small for the time being, there is less and less justification for a zero interest rate policy, given the strong growth and substantial company profits. The BoJ is giving stronger hints that there will be monetary policy changes in the next few months; the yield on 2-year government bonds has increased by 10 points to 0.43% within just over a week.

The other is the US. For quite a long way into January, the markets had believed that the risks for the US economy were increasing and that the Fed’s interest rate hike policy would come to an end at 4.50%, or at latest 4.75%. In view of the Fed’s comments and the latest economic development, this certainty has begun to waver. The nFOMC statement of 31 January still indicated a possible need for further interest rate hikes, and Ben Bernanke, the new FOMC chairman, confirmed this stance in his testimony before Congress. Mr Bernanke said that “in the absence of countervailing monetary policy action, the risk existed that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading to further upward pressure on inflation.”

Moreover, there are no signs at all of the feared slowdown. Quite the contrary: private consumption, which had already picked up in the course of Q4, has strengthened further this year. January retail sales rose by 2.3 % month-on-month. Admittedly, the relatively mild weather boosted sales of apparel and building materials, and gasoline stations’ turnover rose due to higher gasoline prices. But even a conservative estimate comes to an increase in private consumption of clearly over 5% in Q1 (annualized, qoq). The output of utilities was curbed by the warm weather in January, but production in the manufacturing sector rose by 0.7% month-on-month. In addition, the first survey results for February (Empire State manufacturing index and Philly Fed index) show that the trend in manufacturing has remained at least favourable. Even residential construction, which has been causing some concern, is looking strong. Housing starts rocketed by 14.5% in January, thus hitting a fresh high, and building permits rose by 6.8%. Apparently, people had taken advantage of the favourable weather conditions.

Therefore the forex markets have (at least) two potential favourites. Strong growth and relatively
high and rising interest rates are generally good prerequisites for a strong currency. This makes the US dollar attractive. The yen on the other hand has exceptionally strong economic momentum behind it and a new monetary policy era is dawning in Japan.

Given the current developments, we think that the classic carry currencies should be approached with caution. The markets have become used to readily available liquidity from Japan for free. But because of increasing uncertainty about the future path of Japanese interest rates, the risk of yen short positions will be seen as higher. Although the pull of the interest rate difference will remain high, investors will generally become more cautious. As US interest rates have risen, the advantage of investing in higher interest foreign currencies has diminished, so that incurring a currency risk has lost a lot of its appeal for US investors.

The rates between the three major currencies are more difficult to assess. Volatility in the USDJPY exchange rate will probably increase, but the trend will be less pronounced. The euro, on the other hand, is in a way “pig in the middle”: growth is solid but not really exceptional; the level of interest rates is rising, but will remain clearly below that in the US. We therefore expect both EUR-USD and EUR-JPY to weaken somewhat.

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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