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Friday September 29, 2006 - 14:53:42 GMT
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FX Briefing 29 September 2006

FX Briefing 29 September 2006
• Growth still robust in Japan, price upward trend intact
• ECB remains cautious despite falling inflation rates

Further yen depreciation unlikely

Last Thursday’s Philly Fed shock lifted EURUSD over 1.28 again for a short time and pushed USD-JPY down towards 116. However, at the beginning of this week, the US currency firmed up again and is now trading against the euro at around 1.27 – just under its five-month average. The yen weakened again significantly both against the euro and the dollar, trading close to the highs reached during the past weeks and months: EUR-JPY is approaching the 150 mark again, and USD-JPY 118.

Yen: weighed down by interest rate disadvantage but fundamentally undervalued
The forex markets had been assuming that the Japanese government would react to the more or less discreet criticism of the yen’s depreciation coming from Europe (and possibly Asia as well). Therefore, the new finance minister, Koji Omi, unsettled the markets mid-week by stating that he saw no necessity to comment on the yen’s exchange rate against the euro or to take action in this matter. But later on he modified his statement and, using recent political-speak, admitted that the EUR-JPY movement had been “a little rough”.

The latest economic data from Japan paint a mixed picture: it seems that private consumption has been weak in the third quarter: price-adjusted living expenditure data declined again in August for the third time running. Machinery orders were disappointing too, which was interpreted as a bad sign for investment activities. However, there are contradictory indications here, as the BSI Survey (the finance ministry’s survey) for the third quarter shows a further upward correction of expected investment expenditure in the current fiscal year. The BoJ’s Tankan, which will be published at the beginning of next week, could shed more light on this.

In contrast, production has been developing strongly. If the level remains unchanged in September, there would be an increase of 1.3% for the whole quarter, considerably more than in the last two quarters. Foreign trade is probably mainly responsible for this. It looks as though there will be a sharp increase in the current account surplus in Q3. This surplus could turn out to be even higher in real terms because of higher import prices in July and August.

In our view, the Japanese economy could quite possibly show solid growth again in the third quarter. At the same time, the latest consumer price data confirm that the upwards trend is still intact, despite the change in level caused by the revisions. The CPI core rate (excluding fresh foods) is currently about 0.3% year-on-year and is likely to accelerate to over 0.5% by the end of the year. The release of the BoJ’s biannual Outlook Report at the end of October is being awaited with suspense. The expectations published in it will in future form the basis for monetary policy decisions. We do not see the central bank revising its general willingness to raise interest rates.

The main reason for the yen’s sustained weakness is still the fact that Japanese interest rates are lagging far behind those of most other currencies, and the resulting portfolio flows into higher yielding foreign assets. However, in case of doubt, the Bank of Japan is more likely to be slightly less dovish than markets are pricing in at the moment – particularly with a view to the Outlook Report. Also, the new government does not seem to want to tax its trading partners’ tolerance regarding the yen’s depreciation any further. It does not want the high Japanese current account surplus of over 3.5% of GDP to be widened even more as a result of depreciation. On the whole, we therefore see little chance of USDJPY and EUR-JPY sustainably breaking out above the present trading range.

ECB remains cautious
Next week the ECB Council is holding its monthly meeting. Its decision to raise the refi rate to 3.25% is a forgone conclusion: the hawkish rhetoric in combination with repeated ECB comments about the necessity for strong vigilance are fairly clear indications that an interest rate hike is imminent.

In contrast, the ECB’s stance on the changed inflation situation is still not known. Particularly because of the significant drop in energy prices (crude oil is currently around $62/b), the inflation rate in the eurozone fell to 1.8% in September. On the basis of current figures, it is not likely to exceed the upper inflation limit as much as had been originally predicted (2.2% rather than 2.4%). In that case, the German tax increases would be the only reason why the target would be missed.

However, the ECB is not likely to alter its course and replace strong vigilance with relaxed calm. Firstly, energy prices are volatile, and the fact that they have eased recently could prove to be a temporary development. Price increases in autumn would be unusual, but the ECB is hardly likely to be influenced by one month’s movements. Secondly, in its warning about inflation
risks, the ECB refers to medium-term growth trends and money supply developments. As growth risks diminish with falling energy prices, the environment for passing pent-up cost pressure on to consumers would tend to become more favourable; the same also applies to potential price risks in connection with the “ample liquidity” available.

The ECB has often reiterated that it does not base its monetary policy on the developments in individual months. Therefore it will presumably only modify its position slightly; the improvements will probably initially be classed in the category “smaller short-term price risks”. As ECB president Jean-Claude Trichet will have to justify the more or less unchanged ECB policy, the impression he makes could be on the hawkish side.

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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