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Friday February 2, 2007 - 17:20:16 GMT
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FX Briefing 2 February 2007

FX Briefing 2 February 2007
• Fed sees progress in combating inflation
• G7 divided on yen
• EMU inflation in 2007 expected to be below 2%

Reduced inflation concerns: first Fed, then ECB?
Both the euro and the yen strengthened somewhat against the dollar during the course of the week. The EUR-USD movement to over 1.30 was triggered by the surprisingly weak Chicago purchasing managers’ index. However, the real reason was probably the markets’ more cautious assessment of further growth prospects. Furthermore, by indicating that the inflation outlook has improved, the Fed has moved a bit further towards a neutral position.

At 3.5%, US GDP growth was slightly higher in Q4 than the consensus forecasts, but markets had probably been secretly counting on a better result. Thus the market quite happily digested the figures without however gaining fresh impetus from them. This gap was filled by the Chicago purchasing managers’ index, which unexpectedly fell below the expansion threshold of 50 in January. This led to doubts, which have in the meantime been confirmed by the national ISM index, as to whether the series of favourable economic data would continue this year. EUR-USD had been moving in a trading range of about 1.29 to 1.2960 during the first half of the week, but rose to over 1.30 after the release of the Chicago data.

The dollar was weakened further by price and wage data. The PCE core deflator shows that inflation slowed a little further in the fourth quarter; however, at an annualised 2.1% qoq, it was just slightly above the Fed’s comfort zone. Employment costs rose 0.8% in Q4, down from 1.0% in the previous quarter.

Admittedly, neither of these developments is revolutionary. But the figures show that, notwithstanding the latest economic data being more robust again, the Fed’s monetary policy is having the desired effect. In any case, the Fed seems to be sufficiently confident of inflation risks being under control to downgrade them slightly: the FOMC statement issued on Wednesday said that core inflation readings had improved modestly in the last few months.

Yen is G7 bone of contention
But there was headwind for the dollar from somewhere else too. In the past, G7 meetings and similar major political events have often caused unrest on the forex markets. It was usually the US side trying to apply international pressure on China to make its exchange rate policy more flexible. In the run-up to the G7 finance ministers’ meeting in Essen on 9-10 February, this time it seems to be the Europeans aiming to bring the problem of the yen’s distinct weakness into the spotlight.

Understandably, the Japanese side is keeping a low profile on this subject. In contrast, the US position is unclear. Treasury Secretary Henry Paulson, when discussing exchange rate policies in the Senate on Wednesday, focused on China again. The only comment made by Mr Paulson with regard to the yen, was that he was monitoring it very closely, and that, unlike China, the Japanese government did not intervene in the forex market, and that fundamental factors were determining the exchange rate.

Due to the Japanese currency’s status of being under observation, the yen rose initially. However, it looks as though the US government is not particularly interested in giving a political signal on the yen at present. This is probably partly because the appreciation of the dollar against the yen has been quite moderate up to now: USDJPY is only 5% over the average of the years from 1999 to the present day (in comparison: EUR-JPY and GBP-JPY are at least 25% over). Another reason is that China’s exchange rate policy is undoubtedly more in the public eye in the US. Finally, however, Mr Paulson’s argument that the exchange rate of the yen is determined by market powers is also justified. At least amongst market economy purists, this speaks against political intervention attempts to influence the development of the exchange rate.

However, financial market stability is an important topic at the finance ministers’ meeting, e.g. with regard to hedge fund supervision. If on the one hand the US government sees certain investment strategies such as carry trades as a risk to the financial system because they can snowball, it cannot on the other hand simply put exchange rate development down to the free play of market powers.

Seen in this light, shorting the yen is risky, particularly as the Canadians seem to be leaning towards the European position. Moreover, the Chinese will also be at the G7 meeting, and they are unlikely to understand why their current account surpluses are deemed to be worse than those of the Japanese. Furthermore, Japanese GDP data for Q4 is due to be released on 15 February. We expect them to show that the Japanese economy has rebounded, in which case, a BoJ interest rate hike on 21 February would be more likely. Last but not least, the Chinese New Year celebrations start on 19 February. During this period, rampant political speculation sometimes prevails, and the markets are relatively disturbance- prone.

Inflation: ECB can relax a little
At the press conference at the beginning of January, ECB President Jean-Claude Trichet had hinted in a roundabout way that market expectations of an interest rate hike in March were not in direct contradiction to the ECB Council’s assessment. Thus it is a foregone conclusion that interest rates will be raised to 3.75% at the beginning of March. Markets are expecting a semiofficial announcement of this step in the form of a “strong vigilance” statement at the February meeting’s press conference. A few ECB Council members have been warning constantly about inflation risks, thus confirming the markets’ view.

We are not ruling this out completely, but we see a distinct possibility of the ECB loosening monetary policy somewhat in the near future. As expected, the development of inflation in the eurozone was much more favourable in January than the ECB had been assuming up to now. Due to sustained low energy prices and relatively little passing-on of the VAT increase in Germany, the EMU inflation rate could remain below 2% in 2007, thus on target. Furthermore, the first economic indicators for 2007 are showing a slight loss of momentum, particularly the climate indicators: the ifo business climate index and the EU Commission’s survey results deteriorated somewhat in January. In addition, a lot of the last few months’ data have been distorted because of the mild weather. Eurozone growth is not likely to rise above potential in 2007. We are therefore sticking to our opinion that the interest rate hikes priced in by the market are exaggerated. Like the Fed, the ECB could possibly signal reduced inflation risks as early as next Thursday.

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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