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FX Briefing 25 August 2006 - Euro falls back after a good start to the week

FX Briefing 25 August 2006

Highlights
• Negative ZEW data pushes euro well below 1.29 again
• Fed representatives consider inflation risks greater than slow growth
• Bernanke and FOMC minutes could revive interest rate hike expectations

Euro falls back after a good start to the week

At the beginning of the week, EUR-USD succeeded in moving above the 1.29 mark after all, but then the European single currency dropped below 1.28 again. On the one hand, a German expectations indicator gave surprisingly negative signals; on the other, a Fed representative made relatively hawkish comments about inflation risks and possible further rate hikes in the US. Consequently, the dollar firmed up against the yen too despite weak housing sector data. Japanese inflation data, which had been revised downwards, also contributed to this on Friday, as now the Bank of Japan might not raise interest rates again so soon. At the end of the week, EUR-USD was trading at 1.277 and JPY-USD at 117.25.

In August, the ZEW economic sentiment index for Germany fell by 20.7 points – almost as much as in the previous month – to minus 5.6 points, thus entering negative territory for the first time in five years. Apparently, financial analysts are expecting a significant economic slowdown due to the 3 percentage point rise in VAT at the beginning of next year. However, the assessment of the current situation rose sharply by 10.3 points to +33.6, thus putting the negative figure for the future into perspective. Furthermore, despite a further slight decline from 105.6 to 105.0, the more significant ifo business climate index remained close to the 15-year high reached in June.

After the last FOMC meeting at the beginning of August, most financial market participants are not expecting the US central bank to raise the key bank rate further, but rather to start thinking about cutting interest rates in view of the slowdown in economic momentum. For one of the reasons given for the pause in the last statement was the fact that economic growth and inflation were likely to moderate due to the lagged effects of the interest rate hikes so far. However, the speech held by Michael Moskow, president of the Chicago Fed, gave rise to doubts as to whether the Fed had in fact reached the end of the tightening process or whether it was just pausing. In Mr Moskow’s opinion, the risk of the inflation rate remaining too high is greater than the risk of economic growth slowing down too much. He sees a danger of rising inflation expectations, if core inflation rates, which are currently at around 2½ %, do not come down to the Fed’s “comfort zone” of 1 to 2% quickly enough. Furthermore, he has reduced his estimate of potential growth to around 3%, so that inflationary pressures could arise even at a slightly slower pace of growth than in previous years.

If Fed chief Ben Bernanke expresses similar sentiments at the Kansas City Fed’s Jackson Hole Conference this weekend, interest rate hike expectations are likely to be fuelled again or at least rate cut expectations could be dampened further. Next Tuesday, the Fed is publishing the minutes of the FOMC meeting in August. These will probably focus not only on the slowdown in economic growth, but also on remaining inflation risks – if only because Jeffrey Lacker had voted against the interest rate pause and advocated raising the fed funds rate to 5.5%. The minutes will probably make it clear that, despite the rate hike pause, the central bank still has a tightening bias which it may maintain for some time to come.

Preview of an eventful week
Not many data were released this week, at least on the US side, but next week there are several significant indicators and events on the agenda. In the eurozone, the focus will probably be on the ECB Council meeting on Thursday: as the ECB already raised the central bank rate at the beginning of August, there is not likely to be a further rate hike at this meeting. Although money supply growth probably slowed down somewhat in July and the harmonised EMU inflation rate will probably fall to 2.3% year-on-year in August after improved German price data, Mr Trichet will signal that the central bank wishes to raise the refi rate further. Growth and inflation projections will probably be revised slightly upwards; particularly for this year, due to the surprisingly strong growth in Q2. This would provide a good basis for preparing markets for the next interest rate hike at the beginning of October.

In the USA, apart from the FOMC minutes, the markets will be focused on the ISM index and the August labour market report on Friday. The consensus is reckoning that the purchasing managers’ index for the manufacturing industry will be somewhat firmer again and that non-farm payrolls will only have increased slightly more than in July. Then only 113,000 additional jobs were reported, which corresponds roughly with the three-month average. However, several Fed representatives have indicated that around 100,000 additional jobs monthly, and not, as previously thought, 150,000, correspond with potential, because labour force growth has slowed down. Thus less employment growth would not be an indication of non-inflationary growth below potential.

Despite weaker indicators, the ECB will probably make it quite clear that the normalisation of interest rates at the short end will continue. This will have a positive impact on the euro. However, the fact that the Fed is tending towards further tightening rather than an interest rate cut, is having a stabilising effect on the dollar.

Peter Meister +49 69 718-2600
Economics Department
+49 69 718-3642
volkswirtschaft@bhf-bank.com
Foreign Exchange Trading
devisenhandel@bhf-bank.com
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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