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Friday February 9, 2007 - 18:09:33 GMT
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FX Briefing 9 February 2007

FX Briefing 9 February 2007
• ECB signals interest rate hike in March to 3.75%, further outlook remains open
• M3 growth distorted by foreign transactions, credit expansion slowing down
• Japanese government intervention to support yen not a serious option

USD-EUR-JPY: still moving sideways
In the first half of the week, the European currency went through a bit of a weak phase and EUR-USD fell to 1.2920. Subsequently, the euro rose over 1.30 again but at the end the week suffered a slight loss. EUR-JPY followed a similar pattern: the euro dropped to 155.27 temporarily, but is now at just over 158, i.e. in the upper part of its trading range over the last few weeks. USD-JPY weakened to about 120, but recovered to about 121.60 later in the week. Thus, all in all, the sideways movement of the last few weeks has continued.

ECB monetary policy and the EUR-JPY discussion in the run-up to the G7 finance ministers’ meeting were the main topics this week. Markets pricked up their ears last Friday when Market News International (MNI) reported that the ECB could postpone the interest rate hike envisaged for March and that, contrary to expectations priced in to the yield curve, further rate rises were not being considered.

ECB: no plans after March
Indeed, the MNI story tallies well with our own view, that the ECB is veering towards an interest rate hike pause, given improved inflation prospects and moderate growth. After last Thursday’s ECB Council meeting, however, it looks likely that we will see a refi rate hike to 3.75% in March: by changing from “closely monitoring” to “strong vigilance”, the ECB has made its intentions quite clear. As far as we can see, there is nothing in the ECB Council statement nor in Mr Trichet’s comments at the press conference, which speaks against starting to move sideways as from March. The latest economic indicators have turned out to be quite mixed: generally weaker EMU sentiment indicators, lower production and industrial new orders data from Germany, but stronger production figures from other European countries. GDP data for the fourth quarter, due to be released next week, are likely to be sound at about 0.5% quarter-on-quarter, but not outstanding. Furthermore, weather conditions and the German VAT rise pose more of a downward risk to growth in Q1 and Q2.

Jean-Claude Trichet’s remarks that inflation in 2007 is already done, and that the ECB’s monetary policy is focused on the medium-term, are not inconsistent with the idea of a pause in tightening. As early as December, the ECB’s projection for inflation in 2008 was 1.9%, i.e. on target. In our view, there is no need for this medium-term forecast to be revised upwards. However, the fact that the German VAT hike has only been passed on to a limited extent and that there have been no second-round effects from energy price increases, proves that, despite growth acceleration, competition is keeping inflation at bay.

Although the ECB has paved the way for an interest rate hike, its assessment of inflation risks
has remained noticeably more restrained than in autumn 2006. From the end of August to November, the risks were described in the summary as “clearly on the upside”, but since December, the ECB has referred to them as being “on the upside” only, despite all the warnings about the dangers of excessively high wage agreements.

M3: hard to interpret
The ECB seems to be focusing more on monetary development this month. Thus it says in the statement that “continued strong money and credit growth confirm the view that the underlying rate of broad money expansion in the euro area remains vigorous, with no evidence as yet that the steady upward trend observed since mid-2004 has been halted or even reversed.” The chart below shows the development of money supply M3, loans to private sector (non- MFIs) and external assets (flows, three-month moving averages).

This chart also allows a different interpretation from the ECB’s: although M3 growth is at an extremely high level, credit momentum seems to have slowed down significantly, especially compared with the first half of 2006. This fits in with the news that housing loans have been slowing down. The main reason for money supply growth being so strong is the massive increase in external assets in November and December. This impetus from abroad seems to be connected with exchange rate movements and/or securities transactions and thus of a temporary nature; the ECB has not to date given any explanation for it either. If this inflow were to cease, money supply growth would probably slow down significantly. Furthermore, it should also be clear to the ECB that investing at the short end of the market becomes more attractive if short-term interest rates are close to, or even higher than, long-term rates.

Yen: uncertainty will still remain after G7
With regard to the EUR-JPY discussion, we already said last week that a strong signal that the yen should be appreciated cannot be expected from the G7 meeting. However, given Q4 growth data and the impending BoJ meeting, there is still a risk that the yen will appreciate. Exchange rate gains in EUR-JPY or USD-JPY after the G7 meeting could prove short-lived.

The idea started by the media, that Japan could intervene in the EUR-JPY market, is unrealistic. Firstly, the Japanese government does not seem inclined to endanger the Japanese upswing’s main pillar of support. Secondly, from a financial market stability point of view (carry trades), the consequences of such a step are difficult to foresee. And last but not least, it should be borne in mind that the majority of Japanese foreign currency reserves are in dollars. Japan could make use of the euro system’s credit lines, but in that case the Europeans could intervene directly themselves.

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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