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Friday March 3, 2006 - 21:00:41 GMT
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FX Briefing 3 March 2006

• Japanese government signals agreement to monetary policy shift
• China allows renminbi appreciation to accelerate; US political pressure increases
• ECB raises growth and inflation forecasts and signals further rate rises

First the BoJ, then the ECB: dollar on the defensive

The yen started the week with further gains, after government members, including prime minister Junichiro Koizumi, had signaled their agreement to a monetary policy shift. As soon as trading began on Monday, USD-JPY slipped from over 117 to below 116. The drop in EUR-JPY was even more pronounced – from just under 139 to a temporary low of 137.25.

The dollar remained on the defensive for the rest of the week as well. No sooner had the monetary policy shift in Japan been more or less digested, than the debate on the appreciation of the renminbi reappeared on the agenda. The development of the renminbi’s exchange rate shows clearly that since the Chinese New Year festivities, the monetary authorities have been allowing the appreciation of the renminbi to accelerate. In over six months of a more flexible exchange rate system, the Chinese currency had only appreciated by a meager 0.6%. In the last four weeks however, USD-CNY has gained a good 0.2% – not that much, but a start. Many market participants can see further upward potential here, especially as political pressure on China is growing in view of President Hu Jintao’s forthcoming visit to the US and the fear that the Chinese exchange rate policy will be classed as “currency manipulation” in the US Treasury’s next report to Congress – both are in April.

Whereas after the inital losses, USD-JPY just about managed to hold its ground around the 116 mark, the US currency weakened further against most other Asian currencies. However, the release of Japanese economic data on Friday was followed by profit-taking.

US economic data had a mixed effect on the forex market: the decline in consumer confidence, the Chicago PMI and existing home sales increased market players’ nervousness and weighed on the dollar. Consumer spending had risen substantially in January, which had however been expected given strong retail sales. The core deflator for personal consumption expenditure did not bring any surprises either: At 1.8% year-on-year, inflation was relatively contained. At this rate, there is no additional pressure on the Fed to take action. However, the increase of the ISM purchasing manager index for the manufacturing industry from 54.8 to a strong 56.7, indicates that the US economy is still growing rapidly. The considerable improvement of the employment component also strengthens the argument that, thanks to sustained employment and income gains, private consumption will continue to make a significant contribution to growth.

But it was the European Central Bank which had the biggest impact on the forex market this week. Although the interest rate rise had been widely expected and already priced in, ECB president Jean-Claude Trichet’s relatively hawkish comments at the press conference caused some surprise. The upward revision of the ECB growth and inflation forecasts combined with a clear bias towards further rate hikes, pushed up interest rates significantly over the whole yield curve. At the same time, EUR-USD increased to a good 1.20, while EUR-JPY rose to around 140.

Mr Trichet’s comments confirm our opinion that the ECB is aiming for the normalisation of the interest rate level in the euro area parallel to the expected stabilization of growth. The slight upward revision of the growth forecast for 2006 from 1.9% to 2.1% (middle of the forecast range) is primarily due to the recovery now seeming more stable and growth risks less than feared. However, so far this optimism is based mainly on the favourable sentiment indicators of the last few months; before any further interest rate rises, the central bank will presumably require confirmation in the form of “hard” data.

The slight upward revision of the inflation forecasts to 2.2% for 2006 and 2007 (from 2.1 / 2.0) is partly due to improved growth prospects. But the relatively unfavourable oil price forecast probably had the biggest impact. The ECB’s December projection had assumed an oil price of $58.5/b for 2006/07; however, the new estimate is based on a significantly higher price of $66.1/b in 2006 and $67.5/b in 2007. The bank does not make its own commodity price forecasts; these price assumptions are based on forward prices over a two-week period round the end of January/ beginning of February. And during this period, the oil price was particularly high, thus making the price scenario relatively unfavourable. But notwithstanding, inflation prospects are probably unsatisfactory from the ECB’s point of view.

The market’s relatively sharp reaction to the ECB’s signals, which were not, in our view, really that surprising, might be due to the increased uncertainty about monetary policy. The ECB is trying hard to avoid the impression that further rate rises are a foregone conclusion. But uncertainty has also increased in the other major currency areas: until recently the Fed had given guidance, but it is now stressing that its further policy will depend on the economic development. Moreover, there is a new man at the helm. The Bank of Japan is cautiously advancing into unknown territory, but apparently does not yet have a clear concept as to how fast and how far interest rates should be raised.

All in all, monetary policy has become a lot less predictable across the globe. Last week the BoJ was the centre of attention, this week it was the ECB, and next week the market will initially focus on Japan, where the BoJ might be making its first move. Then the focus will probably shift to the US: there will be a series of data, starting with labour market figures, in the run-up to the next FOMC meeting. With regard to the euro, we therefore doubt that it will be able to hold on to its latest gains.

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


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