NEWS / Monetary Policy

FX Briefing 3 November 2006 - Dollar rangebound again

FX Briefing 3 November 2006
Highlights
??? Slowing growth momentum weakens dollar
??? Yield curve flatter than ever before in eurozone
??? ECB switches lights to red, but keeps mum about 2007

Dollar rangebound again
The dollar weakened significantly this week and has returned to the 1.27 ??“ 1.29 trading range in which it has been for most of the latter half of the year. Once again, the 1.25 mark has proved a difficult hurdle for the greenback. Surprisingly weak US economic data were the reason for the dollar??™s weakness. In contrast, the economic environment in the other major currency areas remained favourable: in the eurozone, sentiment indicators improved again in October, and the Bank of Japan??™s Outlook Report confirmed Japan??™s continued economic expansion. This, plus the prospect of gradually rising central bank rates boosted the yen. At the end of the week, USDJPY was trading at around 117 again.

This week the US indicators gave market players the biggest surprise. The Conference Board??™s consumer confidence for October was unexpectedly weak, and the Chicago purchasing manager index fell way short of expectations too. The next day, the national purchasing managers??™ index also indicated a loss of momentum in manufacturing: it fell to a 3-year low, to just above the expansion threshold of 50. As the US GDP growth rate was only 1.6% in the third quarter, doubts increased as to whether growth could really pick up again as early as the fourth quarter. Capital market rates reacted accordingly: the 10- year yield in the USA has dropped again and, at just under 4.6%, is now significantly below the fed funds rate of 5.25%. The inverted yield curve reflects market participants??™ expectations that, given the slowing growth momentum, the Fed will continue to soften its tightening bias in the coming months and finally even cut interest rates.

As a result of these expectations, the European yield curve flattened considerably last week too. The spread between 2 and 10-year bonds has narrowed to less than 10 basis points. The constant hawkish comments from the ECB are another reason why the European yield curve is so flat. At its press conference on Thursday, the ECB switched the lights to red again as expected by reverting to ???strong vigilance???. Therefore we expect the refi rate to be raised by 25 basis points to 3.5% in December.

The press conference gave few hints as to the direction monetary policy will take in the coming year. However, the fact that the projections due to be released in December were mentioned frequently, suggests that the ECB will base its monetary policy for next year on them. In our view, the Council??™s experts will have to revise their inflation forecasts for this and next year significantly downwards, assuming that the growth rate remains much the same. Moreover, the first inflation projections for 2008 are likely to be below 2%. Therefore, like the Fed, the ECB will then probably remain vigilant but refrain from further action and thus introduce a lengthy
interest rate hike pause.

Although the ECB has switched the lights to red, the tone of the introductory statement was a bit softer in parts: for the first time, slower US growth and a possible stabilization of private households??™ credit growth were mentioned. Admittedly, these factors did not lead the central bank to change its conclusion, but they could gain more significance in the December meeting. Given the lack of important economic indicators next week, the focus will be on the US Congressional elections. Whereas the Republicans will probably maintain their majority in the Senate, the Democrats could win the majority in the House of Representatives. However, this is not likely to have a great impact on the forex markets.

Uwe Angenendt +49 69 718-3648
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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