Friday September 7, 2007 - 16:41:21 GMT
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Forex Research - FX Briefing - FOMC: A big step?
FX Briefing 7 September 2007
Â· ECB puts interest rate hike on hold because of financial market turmoil
Â· More signs that US economic slowdown is underway
Â· Dollar burdened by weak US economy and impending Fed rate cut
FOMC: A big step?
This week there were some movements on the forex markets, but these did not last. Overall, the US dollar fell slightly against most currencies. EUR-USD strengthened to just under 1.37, and USD-JPY was just over 115 at the end of the week.
At the moment, the forex market is getting contradictory signals: on the one hand, equity markets appeared to be quite robust. The Dow Jones actually rose slightly during the course of the week, and is now less than 5% below its all-time high in June. Although the Dax has fallen more sharply, it has still gained around 15% so far this year â€“ an outstanding performance compared to other industrial countries.
On the other hand, money markets remain distorted in spite of central banksâ€™ liquidity injections. The overnight rate at times reached 4.80%; three and six-month interbank rates rose to over 4.70%. Credit markets remain frozen. Central banks in Europe and the US are signaling willingness to help. The ECB Council put interest rates on hold, referring to financial market volatility and uncertainty as to the macroeconomic impact of the financial market crisis. The European central bankâ€™s base scenario has not changed; its growth forecast remains favourable and it thus still sees inflation risks in the medium term. However, the bank appears to be losing confidence in the base scenario. At any rate, the ECB has avoided using any key words; it seems that an interest rate hike is no longer on the cards, at least not for the next two months.
Irrespective of the possible consequences of the financial market crisis, eurozone economic data are revealing that growth is slowing down. Taking the average GDP growth rates in the first two quarters of this year, economic growth was 0.5% per quarter. This is probably below potential. The various sentiment indicators are still on a high level, but the majority are tending downwards. Moreover, expectations have been declining recently. German industrial new orders fell by 7.1% in July. After the strong increases of the two previous months, this is no cause for alarm, but it confirms that such high growth rates cannot be sustained for ever. Thus in our view, economic growth will come down, even if the current credit crisis does not significantly hurt the real economy.
Judging by comments from Fed representatives, it looks as though the Fed is expecting the economy to slow down significantly in the second half of the year. Several central bank representatives are now admitting that the problems in the housing sector are more serious and likely to be more sustained than originally assumed. The â€śrwordâ€ť is no longer taboo: according to William Poole, president of the St. Louis Fed, a voting member of the FOMC, and well known as a hawk, the likelihood of a recession in the US has increased. The OECD has reduced its growth forecast for the US to 1.9%, the International Monetary Fund has also announced a downward revision. Surprisingly, even the ECB is talking about a â€ślikely slowdown in the USAâ€ť.
Most observers, including ourselves, are convinced that the US central bank will cut the fed funds rate at the next FOMC meeting on 18 September. The question now is rather whether there will just be a 25bp cut, or whether the Fed will â€śgo the whole hogâ€ť and cut rates by 50 bp. In our view, some of the US data are worrying. These of course include the housing market and related financial services. The labour market seems to be deteriorating markedly too. Heavier loan burdens or reduced availability of credit plus higher energy prices are likely to curb private consumption. Consumer confidence has already deteriorated anyway.
However, the economic data available up to now do not really justify cutting interest rates by 50 basis points. The data due to be published prior to the meeting are not likely to change this assessment either. However, a big step could possibly help to ease the situation on the financial markets. It could also (with a time lag) alleviate the burden on mortgage borrowers. The main disadvantage would be that this might give the impression that the Fed is allowing financial markets and the government to dictate its interest rate policy.
We are expecting the impending FOMC meeting to influence exchange rate developments over the next few days. If expectations of rapid US rate cuts increase, the dollar could come under pressure against the euro and the yen.
Stephan Rieke +49 69 718-4114
+49 69 718-3642
Foreign Exchange Trading
+49 69 718-2695
Matthias Grabbe / Klaus NĂ¤fken
+49 69 718-2688
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