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Saturday December 9, 2006 - 11:57:10 GMT
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FX Briefing: Forex market takes a breather

FX Briefing 8 December 2006
• FOMC acknowledges economic weakness, but remains optimistic in the long term
• ECB goes into stand-by mode
• Strategic dialogue between USA and China fuels Asian FX expectations

Forex market takes a breather
The dollar’s weakness is currently one of the main topics of conversation, but the forex market has in fact entered a consolidation phase. During the course of the week, EUR-USD hovered around 1.33, with a slight downward tendency. The pound took a bit of a battering: after having shot up as high as 1.9847 in the second half of November, it dropped to 1.9620. Only the Asian currencies, particularly the Korean won, managed to stand firm against the dollar. USD-JPY touched 114.50 at one point, but looks as though it will be over the 115 mark at the end of the week.

Given some quite favourable US economic data, profit taking was probably mainly responsible for the stabilisation of the dollar. Whereas the ISM manufacturing index turned out really bad, the ISM non-manufacturing index did extremely well. In addition, as the Fed is still sounding optimistic about the economy, next Tuesday’s FOMC meeting might not after all confirm the markets’ expectations that interest rates will soon come down. Therefore short-term investors in particular will be anxious to realise their profits.

ECB goes into stand-by mode
The ECB is probably another reason for the dollar bears’ caution. The European central bank might not have renounced the idea of monetary tightening for good, but as the inflation outlook has improved significantly, and growth momentum is slowing close to potential, it no longer seems to have any concrete plans to raise interest rates in the immediate future. In its latest statement, the ECB has scrapped the comment that monetary policy would have to be reduced further if the economy continued to develop as in the basis scenario. In our view, it makes a considerable difference whether the ECB’s basis scenario entails monetary tightening or not. Furthermore, the ECB has downgraded the risks to price stability by one notch: it is no longer talking of “significant upward risks to price stability” but only of “upward risks”.

The price development on which the ECB’s new projections are based, is practically conform with stability: 2% inflation in a year in which, according to ECB calculations, 0.5 percentage points alone can be attributed to administrative price increases, cannot seriously be regarded as a problem. Growth already started slowing down in the latter half of 2006, earlier than the ECB had expected. If it continues at this pace – about 0.5 to 0.6% per quarter – the annual growth rate for 2007 and 2008 would be 2.2 to 2.3%, which corresponds with the new growth projections. This would be close to potential growth, and would have to monitored from a monetary policy point of view, but there would be no need for immediate action. Considering that the VAT increase in Germany will create additional economic uncertainty, the US economy is going through a weak
phase and the euro is currently 5 cents more expensive than assumed in the projections, a slightly more restrained monetary policy would seem appropriate. In our view, the markets’ interest rate hike expectations are still excessive.

Asia nervous: BoJ and strategic dialogue between USA and China
One reason for the Asian currencies remaining relatively firm against the dollar is the impending BoJ meeting. Remarks made by members of the monetary policy council have fuelled fears that the BoJ could take its second interest rate step, even though recent economic data has been modest on the whole. The fact that the Tankan will not be published until the end of next week is increasing the uncertainty. It is feared that, if the Tankan results confirm the BoJ’s relatively optimistic view of the economy, interest rates could be raised. However, we are still expecting the Japanese central bank to leave interest rates unchanged for the time being.

Furthermore, the first strategic dialogue between China and the USA is taking place on 14 and 15 December. The high-ranking delegation will include Treasury Secretary Henry M. Paulson and Fed chairman Ben Bernanke on the US side, and Vice-Premier Wu Yi as the main negotiator from China, but there will also be a meeting with President Hu and Prime Minister Wen. The US representatives are certain to push for a more flexible exchange rate policy. As China for its part is trying to curb the excessive growth, the time could soon be ripe for the renminbi to appreciate more significantly.

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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