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Friday June 23, 2006 - 19:59:40 GMT
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FX Briefing 23 June 2006

Highlights
• Fukui scandal and North Korea overshadow BoJ hints of imminent rate hike
• Dollar benefits from stronger risk awareness towards emerging market currencies

USA: A tight monetary policy and the return of growth optimism

It has been a volatile week for the dollar: it stabilized initially given hawkish comments by Fed representatives last weekend, renewed political tension in relations with North Korea and calls for the Bank of Japan governor to resign. At the beginning of the week, USD-JPY rose over 115.50, whereas EUR-USD fell below 1.26. However, comments from the BoJ that it has more or less finished draining excess reserves from the banking system and will start raising interest rates without delay, pushed the US currency down again. Remarks made by ECB president Jean-Claude Trichet while speaking at the EU parliament on the ECB’s now quite familiar assessment of the situation, prompted the markets to mirror this weakness in EUR-USD, which consequently climbed to around 1.2680. USDJPY dropped below 115.

However, on Thursday, the tables turned again. A motley collection of news items boosted the dollar: the tension over North Korea’s missile tests and BoJ governor Toshihiko Fukui’s precarious situation weighed on the Asian currencies. In addition, poor current account data from New Zealand and South Africa put pressure on high yield and emerging market currencies. S&P warned Poland and Hungary that their ratings could be downgraded because of their high budget deficits, which also had a similar effect. The pound sterling fell after the news that David Walton had died. Mr Walton was the sole proponent of higher interest rates on the Bank of England’s monetary policy committee. And finally, the Fed’s impending rate hike also helped to pull the dollar up. Given the stronger US economic indicators for June, the markets have already priced in a further interest rate step in August; there is even speculation as to whether the fed funds rate might be raised by 50 basis points in June.

Fed remains vigilant
In the coming week, market players will without doubt be focused mainly on the Fed. The FOMC meets on Thursday and everything is pointing to a further interest rate hike. We are expecting a 25bp step to 5.25%. In view of the stronger inflationary pressures over the last few months, we think there is unlikely to be a pause in the tightening cycle. The FOMC members are unanimous in their view that the present trend is intolerable. Furthermore, the latest economic data probably allayed fears that the US economy could stall: consumer sentiment seems to have brightened up in June, and initial jobless claims indicate that employment has increased again more strongly after two weak months. Housing market activities also seem to be calming down rather than collapsing. And finally, equity markets have stabilized during the last few weeks too.

Although the economic situation in the US is more favourable again, the development will probably correspond more or less with the Fed’s expectations of continued growth close to potential. Also bearing in mind that for some time the Fed has been emphasizing its uncertainty as to the effect of its past interest rate steps, there is no reason to expect a large rate hike of 50 basis points. Someone who drives into a pitch-black tunnel would not put his foot on the accelerator in order to get back into the light again as quickly as possible.

However, in view of the current data, the FOMC will not be able to adopt a “neutral” policy either, after having raised the interest rate by 25bp. The combination of full capacity utilization, core inflation above the tolerance threshold, cost pressure due to higher commodity and import prices, and a rapidly growing world economy, make us believe that the FOMC will emphasize inflation risks in its statement once again.

The trend towards a tighter monetary policy in the US will probably support the US dollar for the time being. The USA’s significant interest rate advantage compared with other major currencies such as the euro and the yen cannot be denied. Although the ECB is clearly intending to raise interest rates, this will just be at a controlled pace. The BoJ is planning gradual interest rate adjustments and is promising a very low interest rate level for some time to come. Thus it will take a while until the dollar’s interest rate advantage diminishes.

In addition to all this, the US current account deficit argument has lost significance somewhat: on the one hand, the trade balance and current account appear to be stabilizing. In the first quarter, the current account deficit went down slightly; in Q4, the deficit was still as high as 7% of US GDP, whereas in Q1, it was “only” 6.4%. The trade balance data also confirm quite strong export growth. Furthermore, the political tensions caused by the undervalued Asian currencies have now subsided somewhat. Above all, however, the higher risk awareness on the forex markets with respect to emerging market currencies is counterbalancing the argument that, because of the US deficits, international investors have had more than enough of the dollar.

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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