FX Briefing: Euro: breaking out is hard to do

FX Briefing 18 August 2006
Highlights
??? US inflation and economic data indicate stable central bank rates for the time being
??? BoJ??�s gradual approach dampens appreciation expectations for the yen
??? Further ECB rate hikes in the second half of the year already priced in

Euro: breaking out is hard to do
In the wake of the monetary policy decisions taken by the ECB and the Bank of England on the one side (+25 bp respectively)??? and the Fed on the other (rate hike pause), EUR-USD reached 1.29 several times only to fall back again. Then strong US retail trade data and the reports of planned terror attacks on aircraft in the UK pushed the euro below 1.28. Against a backdrop of relatively disappointing growth data from Japan for the second quarter, the dollar continued to strengthen: EUR-USD touched 1.27; USDJPY climbed from around 115 to the region of 116.50.

In this scenario, not even the exceptionally strong European GDP results for Q2 ( +0.9% qoq) had much impact ??� probably also partly due to suspicion that US data to be released during the course of the week would support the Fed??�s hawkish stance and consequently strengthen the dollar. But in fact the US data was unexpectedly dovish. Car price reductions in particular led to core producer prices declining by 0.3% month-on-month in July; after four consecutive monthly rises of 0.3%, core CPI ???only??? rose by 0.2%; industrial production managed an increase of 0.4% month-on- month, mainly due to utilities??� higher output; and the New York Fed??�s Empire Manufacturing index did not rebound in August as expected, but continued to slide.

However, despite all this bullish impetus for EUR-USD, progress remained limited. Although the common currency moved back into the region of 1.2850, it is at the moment not trying to advance beyond this. The dollar??�s relative robustness could have something to do with the Asian market. The yen only gained slightly against the dollar to 115.8 and fell against the euro to a new low of just under 149 on Friday morning. On the one hand, yen carry trades now seem to be gaining popularity again. The BoJ is not due to review the monetary policy situation until the end of October when the next Outlook Report is published. It would start preparing markets in October at the earliest for a possible interest rate step in November. Thus, while all is calm on the Japanese interest rate front, the risk of the yen appreciating seems to be relatively small. Furthermore, the Japanese government has in past years succeeded in hindering any undesired appreciation of the yen. There is thus more incentive to make use of the yen??�s considerable interest rate advantage over other currencies.

On the other hand, China seems to be primarily using administrative measures as well as increases in the minimum reserve rate and interest rate hikes to stop credit and economic growth from getting out of hand. This is despite all demands to make the renminbi exchange rate more flexible and its promise to do so. The PBoC has just raised the one-year lending rate by 27 bp to 6.12%. Therefore, expectations of a renminbi appreciation have