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Forex Market News - FX Briefing 15 June 2007 - Dollar appreciation only moderate despite significantly higher US yields

FX Briefing 15 June 2007
Highlights
• USD slightly firmer versus EUR and JPY; USD-JPY hits 4-year high
• New Zealand central bank intervenes to stop NZD from appreciating further
• Treasury Report calls renminbi undervalued but shies away from escalation

Dollar appreciation only moderate despite significantly higher US yields
The spate of favourable economic data from the US and the sharp rise in US bond yields have strengthened the dollar. However, the movement on the FX side has been modest compared to what has happened on the bond markets: EURUSD has slipped from 1.34 at the beginning of the month to about 1.33, with a short dip to 1.3264. During the same period, USD-JPY has risen from 122 to over 123, thus breaking out of the last few weeks’ narrow trading range (between 121 and 122) and falling to its lowest level since the end of 2002.

New Zealand’s central bank has been causing a bit of a stir. On 6 June, the Reserve Bank of New Zealand had raised interest rates by 25bp to 8.0%, in an attempt to curb buoyant domestic demand. Then, at the beginning of this week, the RBNZ intervened in the foreign exchange market to weaken the NZD. New Zealand is the first industrial country for a long time to intervene in the forex market. Its aim is probably to spread uncertainty amongst market participants by occasionally intervening, thus making carry trades less attractive.

Attention has also been on China again. Firstly, because the latest economic data are signalling that further tightening measures are necessary: The inflation rate reached 3.4% in May and industrial output growth accelerated to 18.1% year-on- year. Secondly, because the US Treasury has released its semi-annual report on international exchange rate policy to Congress. As the strategic dialogue talks between the US and China had indicated, the Treasury abstained from describing Chinese exchange rate policy as currency manipulation to gain a competitive advantage in international trade. Therefore, the latest report gives no reason for the US to take protectionist measures against China. However, the report urges China to correct the undervaluation of its currency. Senators Baucus, Grassley, Schumer and Graham are again pushing for a bill to raise the pressure on China. A draft is to be released next Wednesday. But not much is likely to come of this, as the US government will probably attempt to squash this initiative, or at least weaken it.

Whereas signs of the US economy strengthening again have caused massive losses on bond markets, there has been little impact on forex markets up to now. In the first half of the month, the yield on 10-year Treasuries has risen by about 35 basis points and compared to mid-May by 55 bp to 5.24%. The market has completely priced out any expectations of Fed rate cuts; it is now expecting interest rates to remain unchanged at 5.25% for some time to come. Since the beginning of June, EUR-USD, on the other hand, has dropped by one cent only to 1.33 and is less than four cents below its record high. Against the yen, the dollar hit a 4½-year high, but still the movement from between 121 and 122 to over 123 was only modest.

Why isn’t the dollar appreciating more despite the expected US growth revival? Against the euro, this could be partly due to the fact that interest-rate spreads have not widened all that much. The yield differential between the 10-year Treasury note and the 10-year Bund is only 7 bp higher than at the beginning of June and 14 bp higher than in mid-May. The change in the spread for 2-year bonds is a bit less still – 5 and 10 bp respectively in favour of Treasury notes. Perhaps the markets are regarding the signs of an upswing in the US as an additional argument for sustained growth and further interest rate hikes in the eurozone.

However, it is also possible that forex markets are uncertain as to how long the movement on the Treasury market will last. The latest US data indicate that growth in the second quarter will be quite robust again – in the region of 3%. Retail sales, for instance, suggest that private consumption is doing better than had been expected a few weeks ago; investment in machinery and equipment will probably increase more significantly again in Q2, and residential construction is not likely to be quite as much of a drag on growth as in the previous quarters. The manufacturing sector seems to have firmed somewhat again too.

On the basis of the data currently available, it is not really possible to draw any far-reaching conclusions. The high energy and food prices will probably dampen consumer spending in the US; and higher interest rates for flexible rate mortgages will also place a considerable extra burden on households. In our view, there is little evidence so far to suggest that US economic growth has gained a lot more momentum.

Now that rate cut expectations in the US (which pose an exchange rate risk) are no longer acute, the dollar could become more attractive as a target currency for carry trades. Not so much in relation to the euro, where the interest rate spread is too small to make the risk worthwhile, but more between the dollar and the yen. In the 2- year maturity sector, the spread has risen to well over 400 bp compared with JGBs. It is possible that US investors will be more inclined to invest at home again if relatively attractive yields can be earned there. After all, the real interest rate – based on 10-year indexed T-notes – has risen to about 2.80%, the highest level since the middle of 2002. Thus our forecast for the US dollar remains positive on the whole.

Stephan Rieke +49 69 718-4114
Economics Department
+49 69 718-3642
volkswirtschaft@bhf-bank.com
Foreign Exchange Trading
devisenhandel@bhf-bank.com
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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