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Friday January 5, 2007 - 20:26:00 GMT
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FX Briefing: No free lunch: yen correction hits carry trades

FX Briefing 5 January 2007

• EUR-USD falls back after favourable
• US indicatorsYen rises significantly due to unwinding of carry trades
• ECB likely to remain on stand-by

No free lunch: yen correction hits carry trades
In thin trade during the first few days of the new year, markets continued to focus on carry trades initially. The yen, now the carry funding currency, weakened across the board, particularly in relation to the Australian and New Zealand dollar, but also against the euro, Sterling and virtually all other European currencies. EUR-JPY hit a new record high of just over 158.

However, the carry fraction’s luck was short-lived. On Wednesday, the dollar took the lead: after consumer sentiment had improved significantly in the previous weeks and the housing market had shown signs of stabilising, the US ISM purchasing managers index rose over the expansion threshold of 50 again in December. Moreover, the latest non-residential construction spending data were surprisingly favourable too. In this scenario, despite excellent German labour market data for December, the US currency firmed by 0.8% against the euro to 1.3170, and by 0.5% against the yen to 119.40 (even climbing to 119.68 temporarily, just below last year’s high). EUR-JPY flirted with 158 for a short time, but was unable to sustain this level and fell to around 157 again in the evening.

On Thursday, the euro and most other major currencies, particularly AUD, NZD, CAD, GBP and CHF, as well as the Scandinavian and eastern European currencies, all went down further. But at this point, profit taking and traders squaring up their carry positions seem to have had a decisive influence. These were also fuelled by further press reports from Japan about a possible BoJ interest rate rise in January. At the end of the week, USD-JPY recovered to nearly 118; EURJPY corrected substantially to below 155.

The reasons for the forex market movements over the last few days are not quite clear. The aforementioned benign US economic data are bound to have played a part. But not all the news from the US was good: for instance, the ADP employment indicator suggests that the labour market weakened in December; factory orders fell considerably short of expectations, and the minutes of the December FOMC meeting show that council members’ assessment of growth prospects is now more cautious. It was also remarkable that US bond markets firmed up during the course of the week, which does not really go together with a fundamentally stronger dollar.

However, it was high time for a yen correction, particularly EUR-JPY. Admittedly, Japanese growth had proved unsatisfactory in the second and third quarters. However, it probably rebounded strongly in the fourth quarter, with both domestic and overseas demand making significant growth contributions. In Q4, Japan’s GDP is likely to have increased much more than that of the EMU and the USA. Thus the BoJ’s interest rate rise plans are likely to become more tangible again.

ECB will continue to monitor…
In December, the ECB raised the refi rate to 3.50%. But at the same time it revised its inflation forecast downwards, and changed into “monitoring very closely” mode. Furthermore, it no longer referred to further withdrawal of monetary accommodation remaining warranted, and downgraded its assessment of inflation risks.

The changes in the December statement indicate that the practically automatic rate rise mechanism put into action in the second half of 2006 has been deliberately suspended, in order to take account of the particular uncertainties prevailing at the beginning of 2007.

In our view, there is no reason to tighten up matters at the moment. The data released over the last few weeks basically confirm the ECB’s expectations for the fourth quarter, but do not say much about the first quarter. Even sentiment indicators like the Ifo business climate index for January will not be published before the second half of this month: with the exception of consumer price data, “hard” data for Q1 will not be available until March. Moreover, crude oil prices have just fallen significantly, signalling a positive start to the year from an inflation point of view.

We therefore think it unlikely that the central bank will prepare for an interest rate hike on Thursday, for example, by using expressions like “strong vigilance”. We are not expecting the ECB to change its basically favourable growth picture. It will probably repeat its warning about inflation risks. But it will wait and see how things develop.

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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