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FX Briefing 24 March 2006

FX Briefing 24 March 2006
• Bernanke’s upbeat view on US economy boosts dollar
• Nakahara’s scepticism on policy change not shared by majority of BoJ members
• More favourable inflation development in eurozone curbs rate hike expectations

Speculation on monetary policy moves the market

The US dollar recovered this week: from the end of last week, EUR-USD gained well over 2 cents to 1.1961 and JPY-USD rose by almost 2% to 118. Apart from the positive US economic data, speculation on central bank policy in the major currency areas was again the main reason for the movements. Last week markets had increasingly doubted that the US central bank would raise the fed funds rate to 5% or above. However, remarks made by Fed chairman Ben Bernanke gave rise to renewed interest rate hike speculation. On the other hand, comments made by Shin Nakahara, a member of the Policy Board of the Bank of Japan, initially allayed markets’ fears of a rapid start to tightening in Japan. In the euro area, the lower inflation data could moderate expectations about the extent of ECB tightening.

Mr Bernanke spoke about the yield curve and its implications for US monetary policy. In his opinion, the low long-term interest rates reflected the fact that investors demanded less of a term premium. The high purchases of long-dated securities were a result of more stable inflation expectations, increased intervention by foreign central banks, and pension funds’ higher demand. The low long-term interest rates are having a stimulating impact on the economy, which could speak for more interest rate steps. Mr Bernanke thinks it unlikely that, as so often in the past, the flat yield curve is an indication of a significant economic slowdown to come. Both short-term and long-term interest rates are still historically low in nominal and real terms. However, at the same time he pointed out that the neutral interest rate, the equilibrium rate of savings and investments, was now possibly lower globally than in the past, due to a world-wide savings glut.

On the whole, Mr Bernanke’s comments underlined that the fed funds rate will be raised for the fifteenth consecutive time to 4.75% at the FOMC meeting next week, and that the Fed will probably leave the option of further increases open. Thus the statement will probably focus again on potential inflation risks caused by increasing resource utilization: at 81.2%, capacity utilization is now significantly above the long-term average; at 4.8%, unemployment has now reached, or even fallen slightly below, full employment level. There will doubtless be reference to the fact that policy decisions are going to be increasingly dependent on the incoming economic data, leaving the extent of future tightening open.

Ben Bernanke’s answer to a Congress member’s question regarding the risks of the widening US trade deficit could also have boosted the dollar this week. Although Mr Bernanke did not rule out an abrupt correction of the trade deficit completely, this would not, in his opinion, be disruptive for the economy or the financial markets. However, he did not think that the dollar was likely to crash, but admitted that a gradual reduction of the current account deficit seemed inevitable to him too. In our view, the forex markets could start to focus more strongly on the current account problem again when the end of the American tightening cycle actually becomes imminent.

The yen’s weakness this week was probably linked to BoJ Policy Board member Shin Nakahara’s remark that it was premature for monetary policymakers to announce the end of quantitative easing. At first glance, this seemed to indicate that the first interest rate hike could come a bit later than expected. It should be taken into account, however, that there was a dissenting vote on the policy change (7:1). Given Mr Nakahara’s remark, it appears likely that he was the dissenter and therefore his view is unlikely to be shared by the majority of the Policy Board. We are thus still expecting the overnight rate to be raised to 0.25% around the middle of the year.

The yen’s recent decline is probably connected with the end of the Japanese fiscal year on 31 March and the corresponding, quite substantial interventions by the BoJ on the forex markets. If intervention decreases in April and interest rate rise expectations grow again, the yen will have appreciation potential against the dollar and other major currencies.

The HICP flash estimate for March, due to be released next week, will be crucial for the discussion about the number of interest rate hikes to be expected in the EMU. German inflation is likely to have been quite low according to regional statistics issued by the states. Therefore it looks as if the price development will be more favourable in the other countries too and thus also in the EMU as a whole. The year-on-year inflation rate in the EMU will probably fall from 2.3% to 2.1% in March. Above all, harmonised consumer prices would then remain at or below the 2% mark for the rest of the year. Expectations of a relatively aggressive ECB tightening policy should thus be adjusted accordingly. Furthermore, the weaker Belgian business confidence in March does not bode well for the ifo business climate index in the coming week, and could thus put a damper on growth expectations.
Peter Meister +49 69 718-2600

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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