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Friday May 12, 2006 - 18:18:41 GMT
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FX Briefing 12 May 2006

• EMU, UK and Japan signal interest rate hikes
• FOMC sees less need for further firming
• US government disappointed but patient about renminbi appreciation

Dollar continues to drop

This week the US dollar remained weak. After the euro had broken through the 1.27 mark at the end of last week, the single currency rose above 1.29 this week. The pound sterling rose even more strongly against the dollar to 1.90. Like the euro, it has thus climbed to a 12-month high. The pound has also recovered from its weakness against the euro and is now trading at around 0.68 again – slightly below the average of the last three and a half years. The dollar’s continued downtrend against the yen was particularly marked. Only last Friday USD-JPY had fallen below the 113 mark; now the US currency has dropped below 110.

Contrasting interest-rate signals
The driving force behind the movement is still interest-rate policy. The ECB appears particularly hawkish at the moment. Hardly a day goes by without an – at least restrained – “three cheers” for economic recovery and a warning of impending inflation risks. But the ECB’s laudable intention of preparing the markets for a rate rise in June and indicating that there is an increased probability of further interest rate hikes in the forthcoming quarters, is currently making ECB voices swell to a warning choir. Although the central bank’s communications strategy makes sure that all the singers have the same text, the public listens intently to each single one.

In the UK, the latest Inflation Report has caused a stir. In the past few weeks, more favourable indicators for private consumption in particular had restored optimism about growth. Now the Bank of England is even signalling that interest rate rises might be necessary again: the inflation forecasts in the latest report show that without interest rate hikes, the inflation rate would be slightly over the target in the medium-term. However, BoE governor Mervyn King warns that this should not be overinterpreted.

Finally, market participants think that the first interest rate hikes are drawing nearer in Japan too. According to the press, in its May report, for the first time since 1991, the central bank will use the term “expansion” instead of “recovery” to describe the current economic development. Comments by the central bank president also made an impression. Mr Fukui said that the BoJ was “open to the next step” (after the process of mopping up excessive liquidity), though it had no firm plan for the timing of a rate move at the moment.

Contrary to these three central banks, the Fed is indicating that there is less need for further interest rate hikes. The FOMC statement last Wednesday warns that in view of sustained strong growth and increasing resource utilization some further policy firming might still be needed. However, regarding the meeting at the end of June, the Fed is likely to steer towards a rate hike pause. Moreover, the latest retail sales data also support the theory that the tightening cycle in the US has come to an end for the time being. Without gasoline sales, the increase in April month-on- month of 0.5% dwindles to a miniscule surplus of only 0.1%. Regarding real consumer spending, this speaks for a weak start to the second quarter.

Treasury: China does not manipulate
The long-awaited Report on International Economic and Exchange Rate Policies by the US Treasury turned out to be relatively friendly with respect to China. The Treasury did say that it was very disappointed that the flexibilization of the renminbi exchange rate was going so slowly. It intends to continue pushing for further progress. At the same time it did recognise China’s steps towards building up financial infrastructure and liberalising capital transactions, especially in connection with top-level declarations of intent about increasing flexibility further. The report moreover mentions that China is aiming at reducing its current account surplus by strengthening domestic demand as well as reducing trade barriers and opening its market to foreigners. On the whole, the Treasury does not come to the conclusion that China is using its exchange rate policy to gain unfair competitive advantages.

The gist of the report had already been known before it was published, so the publication as such did not trigger any significant forex market reactions. If the conflict with China had escalated, the markets would probably have assumed that the US administration had a strong interest in a dollar depreciation. But in the end, the gentle approach chosen goes in the same direction. Some observers suspect that the reason behind the Treasury being so “soft” might be concrete promises given by China to let the renminbi appreciate further.

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.
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