Friday August 4, 2006 - 15:30:58 GMT
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FX Briefing 4 August 2006Highlights
â€˘ US interest rate pause a foregone conclusion for markets
â€˘ Trichet announces progressive withdrawal of monetary accommodation
â€˘ BoJ Outlook Report might lead to next interest rate step in Japan
No more drugs for the dollar
While the Fed apparently is still undecided as to whether it will need to administer another dose of higher interest rates on 8 August, market participants seem to have made up their minds that the therapy is finished. The dollar lost more ground even though US growth indicators mostly surprised on the upside this week and the latest price data showed that inflation has accelerated. The interest rate decisions in Europe strengthened this trend. At the end of the week the European currency quoted at just under 1.28. The yen weakened after the rate hikes in Europe, quoting at 115.5 on Friday.
The market is so stoic because it firmly believes that US growth has started to slow down significantly in the second quarter and will continue on this path. The argument runs that this will lessen inflationary pressure and in the end lead to the central bank having to lower interest rates again soon. Whether it starts cutting rates from a level of 5.25 or 5.5% does not seem to make much of a difference from the marketsâ€™ point of view. The PCE deflator has climbed further to 2.4%, which pushes the Fedâ€™s inflation gauge to an annualized 3-month rate of 2.8%, but the marketsâ€™ concern about inflation is currently overshadowed by the discussion about the time lags of monetary policy. FOMC member Janet L. Yellen this week used an analogy from medicine saying that you cannot expect the patient to recover immediately as soon as he has swallowed his pills. In other words: after 17 or 18 interest rate hikes in a row, the FOMC would like to wait and see how the medication is affecting the US economy, and above all inflation.
The prospect of an interest rate pause is weighing on the dollar, especially now that on the other side of the Atlantic both the Bank of England â€“ rather surprisingly â€“ and the European Central Bank â€“ as expected â€“ have raised interest rates further. And on the other side of the Pacific the Japanese central bank governor Atsushi Mizuno has adopted a more hawkish tone. Admittedly, he is one of the hardliners in the Bank of Japanâ€™s monetary policy committee, but his comment that market participants should watch the Outlook Report in October with a view to further interest rate steps, has made it more likely that further hikes will follow this year.
Mr Trichet also sounded rather hawkish at the ECB press conference. Given rising inflationary risks, the Council Members were unwilling to sound more relaxed even after todayâ€™s interest rate hike. Supposing that the eurozone economy develops like the ECB expects, Mr Trichet announced the â€śprogressive withdrawal of accommodationâ€ť. Even after the 25 bp hike to 3%, he still classed the interest rate level as very low both in nominal and real terms. This indicates that he has several more rate hikes up his sleeve. The Council thinks that inflation risks have increased rather than decreased given the rise in crude oil prices. The short-term growth risks on the other hand are seen as balanced, the longer term ones as being on the downside. However, Mr Trichet also said that positive growth surprises are possible, given the impressive development of sentiment indicators in the euro area over the past months.
We expect an even more hawkish tone to prevail at the next ECB meeting at the end of August when the new projections are presented. Since the two-week collation period for the technical assumptions on which the September projections are based ends this week, the results will be influenced mainly by the significantly higher oil price. Given that the oil price is now $4 per barrel higher than the price that the June projections were based on, the inflation outlook for 2007 will have to be raised again. The growth projection will probably remain more or less unchanged. We therefore expect further interest rate steps in October and December.
The diverging monetary policies in Europe and the US are likely to dominate the development on the forex markets in the coming weeks. The euro is therefore likely to remain well supported.
Uwe Angenendt +49 69 718-3648
+49 69 718-3642
Foreign Exchange Trading
+49 69 718-2695
Matthias Grabbe / Klaus NĂ¤fken
+49 69 718-2688
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