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Friday July 28, 2006 - 13:51:37 GMT
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FX Briefing 28 July 2006

• Growth getting close to potential is no reason for doom and gloomECB has made up its mind,
• Fed still in limbo
• Overheating Chinese growth puts renminbi back on the agenda

Pessimism about US growth exaggerated

This week the US dollar remained more or less unchanged. EUR-USD ended the week at 1.267, and USD-JPY was quoted at 115.7. The Beige Book was a little on the dovish side. And some US economic indicators turned out better than expected, which did not really fit in with market participants’ pessimistic outlook. Consumer confidence, durable goods orders and initial jobless claims all came as positive surprises.

Fed still undecided
The Beige Book does say that the general economic trend continues to be favourable, but it qualifies this by pointing out that there are numerous signs of some loss of momentum. The central bankers point out that it is mainly housing and the retail sector which are cooling down, while activity in the manufacturing industry has picked up further. Price and wage increases are generally characterized as moderate. The ability for passing on higher input costs is seen as varied: costs are reportedly being passed on in the transport sector and in some services, but price increases have leveled off in other sectors, especially in retail. But the Beige Book considers the labour market to be tight and tightening further. Whereas base wages rose moderately, compensation for some jobs and for skilled workers increased at a faster rate.

Although the US central bank notes a number of inflationary risks – labour market and wage development as well as commodity prices in particular –, it does not signal any immediate need for action in its overall assessment. Given that the Beige Book moreover focuses heavily on slowing growth, this could be an indication that the Fed might refrain from raising interest rates on 8 August. The fed funds future shows that currently a small majority of market participants believe that there will be a pause in August. However, the central bank is keeping all options open. In our opinion, market participants are being overly pessimistic about the economy, and if they change their mind over the next couple of weeks, the Fed might still decide to raise rates after all. We think that the upcoming data such as the ISM index and the labour market figures might well be better than expected.

ECB goes ahead
Eurozone data, especially the various business sentiment indicators, are pointing to a continued strong economic recovery. Consumer prices will probably be around 2.5% after the last oil price rise to around $75 per barrel and are thus in the upper region of the ECB’s forecast range. There is no doubt that the central bank will raise rates next Thursday. A slowdown in US growth to around 3% is probably included in the ECB’s projections. Moreover, growth momentum in emerging Asian countries has unexpectedly accelerated. Therefore, there is no reason why the ECB should reconsider the planned return to “normal” money market rates.

China back in the limelight
The Chinese renminbi is getting a lot of attention again. The acceleration of Chinese growth to 11.3% in the second quarter has triggered a lively debate about measures to curb growth. The discussion centres on administrative measures such as the reduction of export tax rebates in some sectors and stricter rules for foreign investment, further increases in the reserve ratio and interest rates, and – last but not least – a more flexible exchange rate. Some top-level economists spoke out in favour of exchange rate adjustments and even prime minister Wen Jiabao said that reforms are necessary to increase exchange rate flexibility.

On the other side of the Pacific, US senators Schumer und Graham are on the war path again. Their draft bill for a 27.5% penalty tariff on Chinese imports had been shelved in spring. Now they are threatening to revive it unless China allows the renminbi to appreciate significantly by 30 September.

There is no set direction for EUR-USD in this situation. The China factor poses a risk to the US currency and this limits the rebound potential of the dollar. We still consider the downward correction of interest rate expectations for the euro area following Mr Bernanke’s testimony to be exaggerated. We expect the ECB to switch back to “monitoring closely” but its assessment of the inflation risks will not change. Thus the euro will continue to be supported from this side. As far as the Fed is concerned, a pause in August would not really come as a surprise: the very short end of the curve would probably react, but the longer maturities have already priced in falling money market rates. In our view, the main risk is a correction of the markets’ overly pessimistic attitude towards the US economy. In this case the dollar is likely to benefit. Taking into account that market activity is a little subdued because of the summer holidays, we think that overall a sideways movement is most likely.

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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