Friday April 7, 2006 - 14:51:24 GMT
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FX Briefing 7 April 2006Highlights
â€˘ EUR reaches new highs but drops again after ECB press conference
â€˘ ECB indicates possible rate hike in June
ECB pours cold water on interest rate hike speculation
The dollar started the week on a strong note. The slightly disappointing Tankan and speculation on capital outflows from Japan at the start of the new fiscal year pushed the US currency up. However, things changed rapidly. Firstly, there were rumours that a member of the Chinese government had suggested reducing Chinese holdings of US treasuries and widening the exchange rate band. Secondly, the further increase in the EMU purchasing managersâ€™ indices â€“ just before the ECB Council meeting too â€“ gave the euro a boost.
Thus the following reports fell on fertile ground. The news agency MNSI released (once again) an anonymous insider report according to which the majority of ECB Council members were convinced that a further interest rate hike would not have a detrimental effect on the economy, and the ECB was steering towards a rate step in May. Simultaneously, there were reports which again stirred up speculation about Arab central banks restructuring foreign reserves. After the governor of the United Arab Emiratesâ€™ central bank had dropped hints last week about a proposed shift of foreign currency reserves, all Arab central bankers participating in a meeting in Abu Dhabi were apparently asked to comment on their reserve strategy. Their remarks, which were published out of context, left plenty of room for interpretation: Qatarâ€™s central bank was considering raising the euro share of its foreign currency reserves; the country could raise the euro share to a maximum of 40%. According to comments from Kuwait, the country has ample euro reserves, but is â€śstillâ€ť investing in US treasuries.
As a result of all the reports about planned interest rate hikes and a reallocation of foreign reserves, EUR-USD catapulted from 1.21 at the beginning of the week to 1.23 â€“ and temporarily even higher. As USD-JPY moved mainly sideways within the trading range of 117.50 to 118, EUR-JPY reached an all-time high of 144.88.
The development on the forex market took a new turn after the press conference following the ECB Council meeting. President Jean-Claude Trichet poured cold water on speculation about an interest rate hike in May. He made it clear that the ECBâ€™s interest rate decisions were based on the assessment of medium to long-term economic trends, and not on a smattering of monthly or quarterly data. As we already mentioned in last weekâ€™s edition, the ECB is not keen on â€śshots from the hipâ€ť.
But on the other hand Mr Trichet left no doubt that the ECB would continue with its interest rate hike policy in the current economic environment. The ECB considers the growth risks to be balanced, with growth close to potential. As far as inflation is concerned, the central bank continues to see upside risks, given the rise in energy prices and the upcoming hikes in administered prices as well as strong monetary and credit growth. Mr Trichet explicitly indicated an interest rate hike for June: he said there were no rules about not raising interest rates when meeting out of Frankfurt. He moreover pointed out that the ECB would then have plenty of new information such as quarterly data and new staff projections.
Mr Trichetâ€™s remarks caused the markets to tone down their expectations about the pace of the ECBâ€™s interest rate steps. Previously it was taken for granted that the refi rate would rise to 3.25% by the end of the year, but now market players are divided between 3 and 3.25%. EUR-USD, which had gained ground because the market had expected the interest rate spread versus the USA to dwindle rapidly, has retreated to below 1.22 at the end of the week.
We think that the major force which propelled the euro forwards over the past weeks has been the expectation that the ECB would react relatively aggressively to the more favourable economic data. But now that June seems earmarked for the next hike, market speculation has been reined in. We think that the situation might relax a little further, especially since the hard economic data from the euro area is unlikely to turn out as strong and uniformly positive as the sentiment indicators suggest.
The discussion about the reallocation of currency reserves is also likely to have been triggered by expectations of interest rate policy in the eurozone. If the European central bank raises rates more slowly, the euro will be less attractive to investors, especially since the interest rate level in the dollar area will remain significantly higher than in the EMU or in Japan for some time. The euro will, however, remain supported by Americaâ€™s efforts to push through a more substantial depreciation of the dollar against the Asian currencies and the renminbi in particular. Intriguingly, there seems to be increasing political resistance from Europe which is anxious to prevent a firming of the euro against the dollar as a â€śside effectâ€ś: this is indicated in a confidential paper by the EU Commission which has been leaked and calls for a gradual appreciation of the renminbi. It will be interesting to see whether the Europeans will put this on the table at the G7 or the International Monetary Fund.
The next FX Briefing will be published on 21 April after the Easter break. We wish all readers a happy Easter.
Stephan Rieke +49 69 718-4114
+49 69 718-3642
Foreign Exchange Trading
+49 69 718-2695
Matthias Grabbe / Klaus NĂ¤fken
+49 69 718-2688
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