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Friday May 5, 2006 - 14:38:28 GMT
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FX Briefing 5 May 2006

• Fed to raise rate to 5% and remove standard sentence about further firming
• ECB will continue gradual tightening, provided the economy remains on track
• China concentrates on stimulating domestic demand to correct external imbalances
Euro reaches highest point so far this year

The dollar continued its descent this week, albeit at a slower pace than last week. EUR-USD traded mostly at just over 1.26, only moving to over 1.27 towards the end of the week, which is a 12-month high. The dollar weakened against the yen to 112.34 at the beginning of the week, but then hovered between 113 und 114 in quiet trading because of the bank holidays in Japan and China.

The current exchange rate development is influenced less by individual events or news than by two underlying currents: One is increased political interest in the reduction of the global current account imbalances, the other is that the ECB has replaced the Fed as the leading actor on the interest rate policy stage. This week monetary policy was again in the limelight. Some confusion was caused by reports of Fed chairman Ben Bernanke saying that the markets had misunderstood his recent monetary policy testimony before Congress.

It is in fact unclear what exactly Mr Bernanke said to a journalist at the official White House Correspondence Association Dinner. It seems more sensible, however, to stick with the “written word” rather than unofficial fragments of conversation. In his testimony before Congress Mr Bernanke had indicated that the FOMC would consider pausing for a while to allow “more time to receive information” about the economic development and the effect of the previous interest rate hikes in particular. At the same time he emphasized that the FOMC considers inflation risks to be dominant for the time being and that taking a pause would not preclude interest rate hikes later. Supposedly he said to the journalist it was worrisome that anyone would think of him as dovish and that he had not announced that the Fed is done raising interest rates. This does not contradict what he said before Congress.

We think that the fed funds rate will be raised by another 25bp at the FOMC meeting next
Wednesday. The sentence that “some further policy firming may be needed” is likely to be scrapped from the statement. This would pave the way for a pause at the end of June. At the same time the Fed will probably make it clear that inflationary risks are predominant given above potential growth, rising resource utilization and possible ripple effects of higher costs for energy and other commodities.

In the run up to the ECB Council meeting, favourable economic data and various Council members speaking of several interest rate increases and a normalisation of the interest rate level had fuelled speculation that the European Central Bank might be more aggressive in its tightening. But at the press conference after the meeting this week Mr Trichet gave no indication that the central bank would do so. He said several times that the ECB was very vigilant, which speaks pretty clearly for an interest rate step in June. Just like last month, he moreover pointed out again that meeting outside Frankfurt was no reason not to raise rates. So in this respect the ECB stuck to last month’s screenplay.

But with respect to the interest rate path in the further course of the year Mr Trichet remained relatively vague, just pointing out that the ECB’s decisions were not predetermined. What he did say, however, was that monetary policy accommodation would be reduced further, assuming that the actual economic development follows the ECB’s current main scenario. Apparently, the ECB is planning more than one further interest rate step, the way things look at the moment.

We see no indication, however, that the ECB is planning a 50bp step or a quicker succession of interest rate steps – quite the contrary. Mr Trichet hinted that the new ECB staff projections would not be significantly different from the current outlook. In this case the plans for monetary policy should not be adjusted either. Mr Trichet again confirmed that price data show no second round effects so far. The fact that the interest rate hikes are still preventive also speaks for a moderate pace of monetary policy tightening. And finally, the euro’s appreciation now seems to play a role in the ECB’s considerations. At least Mr Trichet had reason enough to explicitly state (a) that the G7 communiqué does not call for a change in the EUR-USD exchange rate and (b) that the ECB Council is aware of the risk posed by a disorderly correction of the global imbalances.

Because of the bank holidays in Japan and China, the Asian markets were relatively quiet. Market participants listened closely, however, to repeated statements from Japanese finance ministry officials, including finance minister Sadakazu Tanigaki, pointing out (just like Trichet) that the G7 communiqué does not mean that the dollar should be devalued. Maybe the implicit threat of interventions and the generally higher readiness of the Asian central banks to intervene in the market is helping to slow the appreciation of the yen and other Asian currencies a little.

Next week the US Treasury will probably publish its Semiannual Report on International Economic and Exchange Rate Policies. It will be interesting to see whether the US administration will actually accuse China of currency manipulation. Chinese vice finance minister Jin Liqun just said something remarkable at the annual meeting of the Asian Development Bank in India: China was to put the focus of its adjustment measures on the stimulation of domestic demand; he rejected major exchange rate adjustments as this would be too heavy a burden on the economy. The finance minister, Jin Renquing, explained China would not bow to pressure from the major economies and the current exchange rate was appropriate.

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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