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Friday January 12, 2007 - 17:15:22 GMT
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FX Briefing 12 January 2007

FX Briefing 12 January 2007
• EUR-USD falls below 1.30 again,
• USD-JPY climbs over 120
• Bank of England raises interest rates unexpectedly, pound goes upECB still undecided

Economic confidence in USA improving: dollar firm
Favourable US employment data for December at the end of last week plus a slight further decline in the trade deficit contributed to the dollar’s strength. In addition, several Fed representatives confirmed the US central bank’s forecast that growth will slow but then approach potential this year, and inflation will fall gradually, but that vigilance with regard to inflation risks will still be necessary. Thus the US currency appreciated substantially again this week: EUR-USD dropped to around 1.29, the lowest level since 22 November.The USD-JPY movement was slightly more restrained, but rates climbed significantly over 120. Quotations have not been this high since December 2005, and that was only for a short time. Contrary to the general trend, the pound sterling strengthened after the Bank of England unexpectedly raised interest rates to 5.25%.

Stock markets were very nervous in the first two weeks of the year, which probably also supported the dollar. Some emerging markets, including Asian markets such as Korea, Thailand and Malaysia, suffered particularly heavy losses, but so did Russia and Turkey. Presumably, this was due to international investors’ taking profits or increasingly hedging against exchange rate risk in view of the stronger dollar.

Moreover, the ECB helped to push down the euro. Due to economic data remaining favourable, bond markets had been pricing in increasingly aggressive ECB interest rate hikes. Some observers even talked of interest rates rising to 4.25% in the second half of the year. Quite a few toyed with the idea of a further ECB rate hike as early as February.

Higher ECB interest rates not a foregone conclusion
But the ECB has thwarted these expectations, for the time being at least. As we expected, it left its statement unchanged for the most part: it did not change from “monitoring very closely” to “strong vigilance” (which would have fitted the pattern of the latter half of 2006), nor did it alter its inflation risk assessment. Jean-Claude Trichet’s comments at the press conference make it clear that because of the particular uncertainty prevalent at the start of this year, the ECB wants to gather additional information before deciding on how to proceed further.

Nevertheless, Mr Trichet indicated that on the basis of information available up to now, the ECB Council sees no reason to change interest rate expectations with regard to the end of the quarter. Thus at present, a rate rise still seems to be a part of the European central bank’s main scenario.

Therefore the crucial question is: will this scenario still be valid in March, when the actual decision will be taken? In our view, there are good reasons to doubt this. Growth optimism in Europe is soaring as never before. The future is therefore only too likely to hold setbacks. The main reason for our scepticism is the fact that the favourable development of the last quarter was due to the impact of various special factors: the bringing forward of purchases because of the VAT increase in Germany, the unusually mild weather and the oil price decline. But these positive influences will not go on for ever. In addition, tax burdens have increased in Germany and Italy, which will curb growth. And even if the soft landing scenario for the USA comes true, economic momentum in the rest of the world (excluding the EMU) will weaken compared with

Moreover, as far as inflation is concerned, there could be a surprise downwards: the ECB estimates the inflationary effect of indirect tax increases (particularly in Germany) at 0.5 percentage points. This estimate presumes that quite a high proportion of the VAT hike will be passed on to consumers, and can thus be classed as conservative (quite fitting for the ECB.) However, the extensive price reduction campaigns going on at the moment indicate that increases are only being passed on to a limited extent. Furthermore, the decline in the crude oil price to currently around $52 for Brent could push energy prices down again. And finally, in view of the sustained warm weather, there are likely to be bigger than usual price cuts on winter clothing. Therefore on the whole we think it likely that EMU inflation will develop more favourably at the beginning of the year than assumed in the ECB’s and other institutions’ scenarios.

Although the ECB president hinted at being in agreement with market expectations of an interest rate hike in March, this is not a foregone conclusion, as he himself has stressed repeatedly. We think there is a good chance that the reasons for a further interest rate rise in the EMU may no longer apply.

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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