NEWS / Foreign Exchange

FX Briefing 20 October 2006 - Dollar loses momentum

FX Briefing 20 October 2006
Highlights
??? Yen recovers from its lows
??? Fed not likely to change statement
??? US growth in Q3 will remain moderate
??? German inflation falls below 1% in October

Dollar loses momentum
During the first half of the week, the yen was initially at the centre of the action on the forex market. The Japanese currency recovered to around 118.50 temporarily against the dollar, and about 148.50 against the euro. One of the main reasons for the yen??™s recovery was BoJ governor Fukui??™s remark that he would not totally rule out an interest rate rise before the end of the year. This was supported by Russia??™s central bank stating that it was adding the Japanese currency to its foreign exchange reserves. Another reason was the press report suggesting that the Bank of Japan was intending to step up its monitoring of carry trades.

The dollar held its gains against the euro for a while, trading at just over 1.25. However, then, due to the counteracting effects of USD-JPY and the lack of support from the latest economic data, EUR-USD also lost momentum. The European single currency firmed again to over 1.26 at the end of the week; EUR-JPY also rose slightly to over 149.

US economic data did not give markets any clear-cut signals. The New York Empire manufacturing index and the Philadelphia Fed index, which give the first indication of developments in the manufacturing sector, are particularly difficult to interpret this month. Thus the Philly Fed is still in negative territory, but the important subcomponents industrial new orders and deliveries have improved substantially, as have business expectations. The New York Empire manufacturing index shows just the reverse: In October, the current assessment was the highest it has been since June, but the components hardly changed ??“ industrial new orders were actually weaker. And business expectations have become more cautious.

US price indicators reflect the decline in petrol prices very clearly: in September, the annual price rate fell by 0.9% at the producer level, and 2.1% at the consumer level. Thus cost pressure is decreasing and households are gaining more purchasing power again. However, so far the core rates have hardly decreased at all. Core CPI rose by 2.9% year-on-year, the highest level for over ten years; although inflation has slowed down somewhat recently, it is still above the Fed??™s comfort zone ??“ core CPI annualized 3-month change rate is currently 2.7%, the corresponding rate of the PCE core deflator (which the Fed prefers) for Q3 is likely to be around 2.3%.

FOMC and GDP
In the near future, the markets will probably be focused on the US economy. Next week alone, there are two major events on the agenda: firstly, the FOMC meeting next Wednesday, and secondly the release of the advanced US GDP estimate for the third quarter. The Open Market Committee meeting is not expected to give much impetus: in view of the available data and the latest comments from central bank members, the fed funds rate is not likely to change, nor are major changes to the statement expected. The FOMC will probably see its estimate of inflationary pressures reducing confirmed by recent developments. However, in view of relatively stable demand in sectors other than housing, a tight labour market and elevated core inflation rates, it is likely to maintain its tightening bias.

GDP growth will probably have slowed down again slightly in the third quarter. After an annualized quarterly increase of 2.6% in Q2, we expect an increase of about 2% for Q3. Consumer demand could have gone up a little, investment in business equipment and structures and in commercial and public sector construction might have more or less compensated for the weakness in residential construction. Net exports are expected to have a negative influence, and inventories might also pose a slight risk.

The US data due to be released could be one reason why the dollar has weakened slightly. Prior to the release of the publications, skepticism seems to be dominating: for if, contrary to expectations, the Fed does make a move, this is likely to be more in the direction of a softer approach; and if the GDP figures deviate from the forecasts, then they are likely to be lower. At least the frequency distribution of the various market observers??™ growth forecasts is left-skewed, i.e. a relatively large number of analysts are considerably more pessimistic than the median forecast of 2.1%.

This scepticism could disappear once the data has been released and the markets turn their attention more to the future again. For apart from the exact quarterly GDP results for Q3, in our opinion, the US growth outlook seems more favourable at the moment than a few weeks ago ??“ partly because the decline in petrol prices is strengthening consumers??™ purchasing power and because there are slight indications that the housing market could be stabilising.

With regard to Europe, we are expecting the ECB to slow down its tightening pace because of the improvement in the inflation outlook. The October German inflation statistics, due to be published at the beginning of next week, are likely to underline this tendency, showing that inflation has slowed down to a mere 0.9%. The ECB could give a corresponding signal at the next council meeting at the beginning of November. In view of this too, our forecast for the dollar remains favourable for the time being.

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

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