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FX Briefing: Euro: breaking out is hard to do

FX Briefing 18 August 2006
• US inflation and economic data indicate stable central bank rates for the time being
• BoJ’s gradual approach dampens appreciation expectations for the yen
• Further ECB rate hikes in the second half of the year already priced in

Euro: breaking out is hard to do

In the wake of the monetary policy decisions taken by the ECB and the Bank of England on the one side (+25 bp respectively)‚ and the Fed on the other (rate hike pause), EUR-USD reached 1.29 several times only to fall back again. Then strong US retail trade data and the reports of planned terror attacks on aircraft in the UK pushed the euro below 1.28. Against a backdrop of relatively disappointing growth data from Japan for the second quarter, the dollar continued to strengthen: EUR-USD touched 1.27; USDJPY climbed from around 115 to the region of 116.50.

In this scenario, not even the exceptionally strong European GDP results for Q2 ( +0.9% qoq) had much impact – probably also partly due to suspicion that US data to be released during the course of the week would support the Fed’s hawkish stance and consequently strengthen the dollar. But in fact the US data was unexpectedly dovish. Car price reductions in particular led to core producer prices declining by 0.3% month-on-month in July; after four consecutive monthly rises of 0.3%, core CPI “only” rose by 0.2%; industrial production managed an increase of 0.4% month-on- month, mainly due to utilities’ higher output; and the New York Fed’s Empire Manufacturing index did not rebound in August as expected, but continued to slide.

However, despite all this bullish impetus for EUR-USD, progress remained limited. Although the common currency moved back into the region of 1.2850, it is at the moment not trying to advance beyond this. The dollar’s relative robustness could have something to do with the Asian market. The yen only gained slightly against the dollar to 115.8 and fell against the euro to a new low of just under 149 on Friday morning. On the one hand, yen carry trades now seem to be gaining popularity again. The BoJ is not due to review the monetary policy situation until the end of October when the next Outlook Report is published. It would start preparing markets in October at the earliest for a possible interest rate step in November. Thus, while all is calm on the Japanese interest rate front, the risk of the yen appreciating seems to be relatively small. Furthermore, the Japanese government has in past years succeeded in hindering any undesired appreciation of the yen. There is thus more incentive to make use of the yen’s considerable interest rate advantage over other currencies.

On the other hand, China seems to be primarily using administrative measures as well as increases in the minimum reserve rate and interest rate hikes to stop credit and economic growth from getting out of hand. This is despite all demands to make the renminbi exchange rate more flexible and its promise to do so. The PBoC has just raised the one-year lending rate by 27 bp to 6.12%. Therefore, expectations of a renminbi appreciation have diminished somewhat too.

Next week’s macroeconomic data are more likely to underline the weakness of the dollar again.
The few data from the US pertain to the housing market and durable goods orders and will probably be more on the moderate side. However, financial markets are already expecting weak housing market data. It is therefore doubtful whether home sales will be powerful enough to propel the euro over 1.29. The same also applies to durable goods orders, which could be burdened by weaker car and aircraft orders, but apart from that should be quite robust.

On the European front, the focus will probably be on business climate data from Belgium and Germany. We are reckoning with a slight improvement in both countries. But even if the results
turn out to be weaker, which the majority of market participants are expecting, the ECB’s interest rate rise intentions are not likely to be questioned. In view of the positive growth data in the second quarter and the relatively unfavourable inflation data, the ECB will probably revise its growth and inflation projections upwards at the end of August, and at the same time announce an interest rate rise for its next meeting. But markets have pretty much priced in further monetary policy tightening in the EMU; a breakout above 1.29 would therefore be difficult to achieve.

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.
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