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Friday March 10, 2006 - 16:06:54 GMT
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FX Briefing 10 March 2006

Highlights
• BoJ ends quantitative easing, but overnight rate to remain at zero for now
• Dollar strengthens across the board, hawkish Fed pushes US bond yield up
• Investments in high-yield currencies getting riskier

Carry currencies under pressure

As expected, the euro’s gains after ECB president Trichet’s hawkish comments following the press conference did not last long. During the course of the week EUR-USD fell by over a cent to around 1.19. Neither was the yen able to hold its ground after initially strengthening to 116 against the dollar in view of the impending Japanese monetary policy shift. Last Thursday, the BoJ actually brought its quantitative easing policy to a close – sooner than a lot of people had expected. But after a bit of to-ing and fro-ing, market participants came to the conclusion that the BoJ’s future policy might not turn out to be quite as aggressive as already priced in. As a result, USD-JPY rose to over 118 again and EUR-JPY increased slightly to just under 141. Market rumour has it that there were concealed official yen sales after the monetary policy decision in Japan had been announced.

During the course of the week, several emerging market and carry currencies dropped considerably. Most Asian currencies got away relatively unscathed. Losses during the week remained under one per cent and thus less than those of the yen. However, most central and eastern European currencies were hit harder, particularly the zloty, which fell by 3.5%, the forint and the Czech koruna. The Turkish lira lost over 3% against the dollar. Some South American currencies were similarly affected, especially the Brazilian real which lost a good 2%, the Chilean peso and, less severely, the Mexican peso. The New Zealand dollar and the Iceland krona also continued to plummet, dropping 3.4% and 6.3% respectively this week.

On the surface, there were good “domestic” reasons for most of the movements. In Iceland, the current account continued to deteriorate; in Poland the government is attacking the central bank’s independence; in Brazil the corruption affair around president Lula is spreading, in Mexico the impending election is causing political unrest, in New Zealand the central bank is changing from a rate rise policy to a sideways movement. And so forth.

But if one looks hard enough, one can always find a fly in the ointment. None of the weak points are new, but they are gaining more significance because monetary policy is changing worldwide.

Firstly, the US is no longer a low interest rate country. The more US money market rates rise, the more the interest rate advantage of the high yield currencies shrinks. The question then arises whether it is worth taking the additional exchange rate and credit risks.

Secondly, one used to be able to rely on the Bank of Japan for free liquidity, but now the Japanese too are getting ready to raise interest rates. Despite all the BoJ’s assurances that it will proceed cautiously, monetary policy has become a source of uncertainty. Moreover, the strong economic growth and the high Japanese current account surplus are pointing towards an appreciation. So traders putting their money on a permanently weak yen, be warned.

We believe that the willingness to run exchange rate risks will diminish, especially in the case of the “minor” currencies which had been popular during the search for yield in the past years. Investors are more likely to reduce their exposure at the first signs of trouble arising in individual countries. The danger of such movements snowballing is also increasing. Once the flight reflex is triggered, some currencies will be abandoned for no apparent reason. However, we do not expect a panic like during the Asia crisis when investors stampeded out of carry trades virtually overnight. Monetary policy today is treading a lot more cautiously and the economic situation in the respective countries is a lot more robust than in 1997/98.

The latest words from the Fed confirm the impression that for the time being interest rates will continue to be raised in the US. William Poole, president of the St. Louis Fed, for instance, thinks that inflation is currently more likely to accelerate than decelerate given the strength of the global economy. Moreover, Mr Poole does not expect the stabilization of the housing market to cause a significant slowdown in private consumption. His colleague Timothy Geithner of the New York Fed indicated that the interest rate dampening effect of the high foreign capital inflows might have to be offset by a more restrictive monetary policy to keep demand growth and inflation under control.

Labour market data for February and the Beige Book will further underpin the Fed’s relatively hawkish position. Next week’s survey results (Empire State Manufacturing, Philly Fed index UMI consumer sentiment) are likely to be either higher or at least stable at a high level. Data on industrial production, retail sales, housing starts and building permits is likely to be distorted by the cold weather, which will somewhat impair their significance. February consumer prices will probably follow the trend of the previous months, with headline inflation dampened by the decline in energy prices. All considered, we see no reason for the Fed to adopt a softer tone in the run-up to the FOMC meeting on 28 March. Therefore the dollar will remain well supported.

Stephan Rieke +49 69 718-4114
Economics Department
+49 69 718-3642
volkswirtschaft@bhf-bank.com
Foreign Exchange Trading
devisenhandel@bhf-bank.com
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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