NEWS / Government Ministries

FX Briefing September 1, 2006- Weak yen makes carry trades popular again

Highlights
- Revised inflation data und US fears stop BoJ in its tracks
= Political events in September bring Asian currencies into focus

Weak yen makes carry trades popular again
During the course of the week, EUR-USD hovered around 1.28, right in the middle of the trading range of the last few weeks. In retrospect, August proved to be a quiet month. This is all the more surprising because there was a significant change in the markets??™ perception of the macroeconomic situation, and as a result the interest rate situation changed considerably too: market participants have substantially lowered their growth expectations for the USA, pricing out further rate hikes by the Fed and pricing in interest rate cuts. Thus the yield on 10-year T-notes fell by a further 0.25 percentage points to just 4.70 % in August.

However, although this development had originated in the USA, the dollar managed to hold its own on the forex markets. The dollar??™s effective
exchange rate was roughly on the same level at the end of the month as at the beginning. Amongst the major currencies, the yen is the biggest loser, plummeting to the lowest it has been for many years against the euro and the pound Sterling. In August GBP-JPY rose by 4.4% to around 223.60, and EUR-JPY by 2.8% to 150.40. Even the US dollar gained 2.4% versus the yen to 117.40.

Reasons for the yen weakness
The main reason for the yen??™s weakness ??“ and the dollar??™s relative robustness ??“ is the fact that the markets believe that the BoJ has gone off interest rate hikes for the time being. The following factors probably played a crucial role:
??’ Due to the change in the consumer price index??™s base year to 2005, the positive inflation rates have almost disappeared. Looking at the revised figures, one can say at best that the annual core CPI rate has been ???sustainably??? above zero for two months. Thus the main precondition stipulated by the BoJ for ending its zero interest rate policy has not (yet) been fulfilled.
??’ After two years of robust growth, economic momentum seems to have declined somewhat. At 0.2% quarter-on-quarter, Q2 growth was below expectations.
??’ For the BoJ the US economy is a very important factor. Also, it??™s a case of ???once bitten, twice shy???: when the US economy collapsed in spring 2001, the BoJ was forced to take back the interest rate hike which had only been decided in the middle of the year 2000.
??’ The BoJ is not due to review the monetary policy situation until its semi-annual Outlook Report is published at the end of October. Thus at least until then, the interest rate situation should remain more or less unchanged.
??’ The impending change of government in Japan could heighten political pressure on the BoJ to slow down the pace of interest rate hikes. Currently the favourite candidate to replace Junichiro Koizumi is Foreign Minister Shinzo Abe, who is known to advocate a more growth-orientated monetary policy. As there is relatively little prospect of further BoJ tightening in the foreseeable future, yen-based carry trades have become much more attractive again, especially as the interest rate advantage of many currencies over the yen has risen as interest rates have increased across the world. The currencies of countries which have a robust economy and where the currency is supported by a more restrictive monetary policy, are particularly attractive. This applies to the eurozone and the UK, but also to the USA, where the Fed still sees inflation as the main risk. As the US dollar traditionally has a special significance in Asian countries as an investment currency, Japanese investors normally invest in bonds, and the interest rate advantage at the long end has reached over 300 bp, the inflows into the dollar are perhaps notso surprising after all.

What will happen next?
The main reasons for the yen??™s weakness are likely to remain valid for some time to come. The BoJ will probably leave things as they are, at least until the end of October, when its Outlook Report is published; in view of the inflation figures and the general political situation (the LDP is electing Mr Koizumi??™s successor on 20 September), further tightening in the coming months seems unlikely. On the other hand, with EURJPY trading around 150 (just like GBP-JPY), the forex markets are entering new territory. There is some irritation in Europe already about the unequal distribution of the burdens resulting from the desired correction of the global imbalances between Europe and Japan.

In fact, from a macroeconomic point of view, there seems no reason why a country like Japan with robust growth and massive current account
surpluses should depreciate nominally (and even more in real terms), while the rest of the world issupposed to be making an effort to correct the global imbalances. As a rule, markets have not been very receptive to ???fundamental??? argumentsof this kind, particularly when there is no sign of a political solution being sought.

But there are several political events on the agenda this month where global imbalances and currency matters in Asia will probably play an important role: on 7 and 8 September, an APEC meeting will be held in Vietnam. On 19 and 20 September, the bi-annual meeting of the IMF and the World Bank is taking place in Singapore. G7 finance ministers and central bank chiefs will take this opportunity to hold discussions. US Treasury Secretary Hank Paulson will attend all the meetings and visit China in between. And at the end of September, the Graham-Schumer ???ultimatum??? runs out. If there has not been a significant correction of the renminbi exchange rate by then, they are intending to introduce their draft bill into the Senate to impose penalty tariffs on Chinese imports.

The political pressure on the Asian emerging markets to appreciate their currencies will probably be stepped up again in September. The renminbi??™s
pace of appreciation has also accelerated recently, expanding the allowable fluctuation range of ?±0,3 % against the central bank??™s daily reference rate is on the cards. As the yen occasionally acts as a (more liquid) substitute for the renminbi, appreciation speculation could have a stabilizing effect on the yen. However, we are not convinced about this: at least in the years after autumn 2003, there has been no sign of the yen being particularly strong around the time of the IMF and G7 meetings ??“ despite the fact that the Asian currencies are regularly on the agenda.

Stephan Rieke +49 69 718-4114
Economics Department
+49 69 718-3642
volkswirtschaft@bhf-bank.com
Foreign Exchange Trading
devisenhandel@bhf-bank.com
J?¶rg Isselmann
+49 69 718-2695
Matthias Grabbe / Klaus N?¤fken
+49 69 718-2688
Economics Department
+49 69 718-3642

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