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Friday June 30, 2006 - 15:25:59 GMT
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FX Briefing 30 June 2006

• Dollar falls after restrained FOMC statement
• Business climate indicators confirm European economy is gathering momentum
• Eastern European currencies remain volatile; forint drops to all-time low against euro

Currency turbulence in Eastern Europe

In the run-up to the FOMC meeting, exchange rates between the leading currencies remained range-bound. USD-JPY hovered mainly between 116 and 116.50. EUR-USD benefited temporarily from ECB representatives’ hawkish-sounding comments, hints given by the United Arab Emirates’ central bank governor on plans to convert foreign currency reserves into euros, and a remarkably strong Ifo business climate index. However, the factors supporting EUR-USD lost their significance in the light of speculation that the Fed could take a tougher line too. Thus, after a short foray over 1.26, by Thursday evening the euro had dropped again to almost the same level as at the beginning of the week (just over 1.25).

But after the Fed’s interest rate decision, the dollar came under considerable pressure. The euro rose over 1.27, USD-JPY fell below 115. The reason for the correction was a relatively tame statement from the Fed toning down its intention to raise rates further. According to the markets’ current interest rate expectations, the end of the tightening cycle in the USA will be reached after the next rate hike at the latest.

After their weakness over the last few weeks, the Eastern European currencies presented a mixed picture. The zloty and the Czech koruna recovered slightly. The Czech central bank signaled its intention of raising interest rates, which had remained unchanged at a mere 2% since last September. However, after the elections at the beginning of June, the political situation still remains uncertain. The Turkish lira firmed significantly after the central bank raised interest rates substantially again to 22.25%.

On the other hand, the Slovak crown and particularly the forint remained under pressure. In Slovakia, the new left-wing/national coalition government’s plans to increase public spending and raise taxes weighed particularly on the currency. The central bank was forced to intervene in order to keep the crown’s exchange rate losses under control. In Hungary, the forint’s slide continued, despite last week’s interest rate hike from 6 to 6.25%. During the course of the week, it again lost around 1.5% against the euro to about 282. The losses during the course of the month now amount to almost 7.7%, and during the year so far 10.7%.

There are several reasons for the Eastern European currencies’ weakness: in general, the trend towards higher interest rates in the large currency areas is weighing on the Eastern European currencies too, as it is becoming more expensive to finance carry trades, and because investors can earn decent risk-free returns in their own currencies. The more aggressively the Fed, ECB and BoJ threaten to raise interest rates, the more difficult the Eastern European high-interest currencies’ position becomes. This also applies to emerging markets’ currencies as a whole.

In addition, there is the specifically Eastern European factor that the prospect of joining monetary union in the foreseeable future has made convergence trades attractive. Investors are attempting to reap benefit from the fact that, as the entry date approaches, the national yield curve is
gradually merging with the EMU yield curve. However, implementing planned entry to monetary union is proving more complicated than originally thought. ECB, Commission and present EMU members are all against letting the Eastern European candidates in too easily: the entry criteria are to be strictly observed, presumably also because of the present members’ concerns about the big structural differences between the candidates and the core members of the EMU. Estonia’s application for entry in 2007 has just been turned down.

Thus applications, especially from countries with budget problems, are jeopardized. This applies particularly to Hungary, whose deficit ratio rose to 6.1% in 2005, and whose debt ratio is rapidly approaching the 60% mark. Only a few days ago, S&P cut Hungary’s credit rating to BBB+. But the deficit ratios of Slovakia (2.9%), the Czech Republic (2.6%), and Poland (2.5%) are also in the critical zone – particularly when governments are spending generously. Furthermore, the Polish government for instance, is showing little interest in entry. Thus it looks as though, particularly in the case of the three large countries, entry will be delayed until after 2010. Given this background, and in view of the ongoing monetary tightening process in the big currency areas, we recommend exercising caution with respect to the Eastern European currencies for the time being, despite the current easing signals after the Fed’s statement.

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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