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Friday October 27, 2006 - 16:44:17 GMT
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FX Briefing 27 October 2006: BoJ: First Outlook Report in new regime

FX Briefing 27 October 2006
• Markets disappointed by Fed statement, dollar weakens
• Japanese inflation only rising slowly, no immediate pressure on BoJ to act
• ECB switches to strong vigilance

BoJ: First Outlook Report in new regime
In the first half of this week, the US currency firmed slightly, but began to lose ground again after the FOMC meeting. In our view, the reason for the dollar’s weakness is the markets’ disappointment that the Fed did not strike a more hawkish tone. Furthermore, the fact that the FOMC statement was slightly softer reinforced market participants’ worries about the impending GDP data for the third quarter. And last but not least, the surprisingly robust results of several economic surveys in the eurozone, the equally surprising high inflation rate in Germany and hawkish rhetoric from various ECB representatives all served to boost the euro. Towards the end of the week, EUR-USD was approaching 1.27, USD-JPY slipped back to 118.30. On Thursday night, after the release of Japanese inflation data, EUR-JPY firmed to 150.74 for a while thus hitting a new high; EUR-USD temporarily rose over 1.27.

The Fed seems to be reducing – very cautiously – its tightening bias. Admittedly the statement still emphasizes that inflation risks remain and that additional firming could therefore become necessary. Hardliner Jeffrey Lacker is still sticking to his vote for an interest rate hike. But the Fed is beginning to sound more sceptical in its comments on economic prospects. The FOMC states that economic growth has slowed down and that the economy is only likely to expand at a moderate pace in the near future. Furthermore, the FOMC seems to be of the opinion that inflationary pressures are likely to moderate as energy and commodity prices are no longer listed as inflation risks.

More central bank policy
Next week the focus will be on monetary policy again. The Bank of Japan’s policy committee is meeting on Tuesday. An interest rate hike is unlikely to be on the agenda; discussions will probably focus on the Outlook Report, which is published bi-annually. Now that the zero interest rate policy has come to an end, the Outlook Report will play an important part as a communication tool, similar to the ECB’s quarterly projections or the Fed’s Monetary Policy Report. The complete Outlook Report is not due to be released until Wednesday morning (1.11.), but the main messages will probably already be revealed in the “Bank’s View” (the equivalent of the ECB’s introductory statement) and at Governor Fukui’s press conference on Tuesday morning.

In April, the BoJ had forecast a growth rate of 2.4 and 2.0% respectively for the fiscal years 2006/07 and 2007/08, and an inflation rate of 0.6 and 0.8% respectively. In summer, the interim assessment basically confirmed this forecast. After the weak second quarter (despite robust domestic demand!), relatively strong quarterly growth rates of about 0.6% would be necessary to uphold the growth forecast of 2.4% for 2006/07. Although private consumption in Q3 is likely to be disappointing, investment in machinery and equipment, and exports will probably contribute very positively to growth. Thus all in all, the forecast could still be realistic. A significant downward revision of the forecast might be taken as a signal that Q3 has not come up to expectations either.

With regard to the inflation forecasts, the fact that they have been revised and adjusted to a new basis year makes it more difficult to compare “new” and “old”. Admittedly, the BoJ had pointed out in April that results would be slightly lower due to the revision. However, the core rate forecast for 2006/07, estimated at 0.2% year-on-year, is likely to remain well below the 0.6% originally forecast. The annual inflation rate will probably approach 0.5% towards the end of 2006 and will then remain around this level. Therefore, at the moment, apart from the basis year adjustments, there is hardly any “real” need to revise the forecast for 2007/08.

Assuming that growth continues to remain stable, but that inflation lags behind schedule, there would be no immediate necessity for the BoJ to raise rates, although it might be basically inclined to do so. If, at the beginning of next year, inflation increases (and the growth trend is intact), then tightening plans could slowly become more concrete. Judging by forward rates, the market seems to be expecting an interest rate rise to 0.5% at the beginning of the first quarter. In our view, that would be very early. Anyway, we are awaiting the BoJ and its first Outlook Report since the end of the zero interest rate policy with great interest.

During the last few weeks, the ECB has made quite an effort to dispel the impression that the slowdown in inflation in the eurozone has led it to give up its fight against inflation. Thus now all
signs are pointing to the ECB switching to “strong vigilance” next Thursday and raising the refi rate to 3.50% in December. However, this does not affect our fundamental argument: given the ECB’s sharp rhetoric, the tightening pace that the markets are pricing in is very hawkish against a backdrop of lower average inflation and sinking inflation rates in 2007, plus expected slower growth at the beginning of the year. And if the market has already priced in the most hawkish scenario imaginable, the chances are perhaps more likely to be on the other side. This will also limit the upward potential for the euro.

At the moment, the euro is finding it difficult to climb over 1.27USD and 150 JPY respectively, despite the ECB’s rhetoric offensive and positive leading indicators for the euro area. In the BoJ’s case, we think that, although it has a tightening bias, it is not committed to a certain date. There is some potential for disappointment here, which could pull down the yen against the euro and the dollar, particularly in the run-up to the ECB council meeting. However, the effect is only likely to be temporary, particularly as relatively stable economic data from the US (ISM, labour
market) counterbalance it to some extent.

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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