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Friday July 21, 2006 - 14:20:42 GMT
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FX Briefing 21 July 2006

• EUR-USD recovers after Bernanke hints at interest rate pause
• ECB interest rate hikes ahead, EMU growth robust
• Euro might benefit from expected narrowing of interest rate spread

Interest rate pause in the US – second attempt

Following the dollar’s ups and downs this week was more gripping than any action film. Under the impact of the sustained military conflict in the Middle East, the oil price retreated only slowly from its high of almost $80/b, and equity markets remained weak. The greenback, in its (rather unaccustomed) role as a safe haven, firmed against most currencies including the euro and the yen.

The current economic indicators tended rather to trigger fears about possible further central bank rate hikes. Industrial production grew substantially again in June, resulting in a 1.7% increase in Q2 (quarter-on-quarter, not annualised). Thanks to this increase – the biggest since Q4 1999 – capacity utilization went up too, from 81.8 to 82.4%. And when the US consumer prices were released, the dollar rally reached its climax. Core CPI rose in June for the fourth time in a row by 0.3% month-on-month. Thus yearon- year, inflation accelerated from 2.4 to 2.6% (the headline rate, including food and energy, went up to 4.3%).

Against the backdrop of these data, EUR-USD had fallen to just over 1.2460, and USD-JPY was beginning to aim for 118, when, a mere 1½ hours later, Fed chairman Ben Bernanke completely reversed the situation with his testimony on monetary policy before the Senate. Mr Bernanke confirmed what had been hinted at in the FOMC statement of 29 June, namely, that the central bank was expecting economic growth to slow down due to diminishing expansive impulses from the housing market, the burden on purchasing power through higher energy prices and a tighter monetary policy. According to the Fed’s projections, growth in 2006/07 should be close to potential. However, the Fed also emphasizes that there is a risk that high core inflation might not go down as much as expected. It also points out clearly that once higher inflation expectations have taken root, they can only be corrected again at considerable macroeconomic cost.

Mr Bernanke’s comments confirmed market participants’ impression that the Fed was heading towards an interest rate pause, which had already been on the cards in February. A narrow majority are still reckoning with one final 25bp step to 5.5%, but many players believe that rates could be left unchanged on 8 August. The market is expecting the economic indicators for the coming weeks, starting with the GDP data for Q2 next Friday, and then the ISM index and the employment market data, to confirm the picture of moderate growth painted by the Fed. Given that there is only the PCE core deflator for Q2 and for June to come, there is little chance of “nasty surprises” after the last consumer price data. If economic data really turns out to be weak, an interest rate pause in August will become even more likely.

Whereas in the US hopes for an interest rate pause are being nurtured, the eurozone is heading towards a rate hike on 3 August. The ECB Council has signalled this quite clearly by switching to “increased vigilance” and by the fact that the Council is meeting face-to-face in August and holding a press conference afterwards. Also, current eurozone data probably rather underlines the necessity for raising interest rates: in June, French consumer spending on manufactured goods, which is about one fourth of total private household spending, rose by 1.7% month-onmonth price-adjusted, after increases of 0.9% and 0.5% in May and April respectively. Thus in Q2 the increase quarter-on-quarter was 1.5% with a substantial overhang of 1.4% for Q3.

Most European GDP data for the second quarter will not be published until the middle of August (France and Italy 11.8.; Germany, Spain, EMU 14.8.), but it looks more and more likely that Q2 has been an extraordinarily strong quarter. However, as from Monday, the July national business climate indicators, including the ifo index on Wednesday, will start being published. In general, the expectations are likely to be slightly weaker, but the assessment of the situation will continue to be favourable. Also on Monday, the German Länder will start releasing consumer prices for July. In view of the renewed energy price hike, there is no prospect of things easing up on the inflation front. Inflation has probably remained high at 2% year-on-year.

The outstanding eurozone data will confirm markets’ expectations that the ECB will continue with its tightening policy even after raising interest rates at the beginning of August. In this scenario, markets will probably “act out” the narrowing of the interest rate spread between the USA and the eurozone. EUR-USD will therefore tend to remain basically firm.

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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