FX Briefing 17 November 2006
Highlights
??? US economy doing well, inflation slowing down
??? Japanese growth in Q3 on schedule, BoJ remains on stand-by
??? Economic growth in the eurozone resumes normal pace

Conflicting impulses on the forex market
At the end of the week, the dollar had strengthened slightly against most major currencies. EUR-USD was just over 1.2850 at the start of the week, but dropped to about 1.28 over the next few days; during the same period, USD-JPY moved above the 117.40 mark to over 118. This week??™s losers were the pound Sterling and the Norwegian krone. The winners were once again the forint and the Turkish lira, both of which are now well on the way to recovery.

Compared to the quotations of the last few weeks, the US dollar is on the weaker side, despite the firming tendency it has shown over the past few days. Markets suspect that the tightening cycle in the USA has come to an end and that the US central bank could even start loosening monetary policy next year. This is weighing on the dollar. However, these expectations have moderated somewhat recently.

US retail sales confirm the impression that private consumption is still robust. The decline in nominal sales is primarily due to the fall in gasoline prices, and will therefore not affect GDP. Surprisingly, car sales have actually increased. Furthermore, surveys carried out by the New York Fed and the Philadelphia Fed both show an improvement in the manufacturing sector in November. Last but not least, the important NAHB Index rose in November for the second time running. This index, a sort of business climate index for US housing construction companies, had plummeted between October 2005 and September 2006.

In October, the CPI core rate only rose by 0.1% month-on-month, and the annual inflation rate fell from 2.9 to 2.7%. Apart from the sharp decline in energy costs, inflation was curbed above all by lower prices for clothing and cars. As regards interest rate expectations and the exchange rate, the moderate price development weakened the impact of the stronger economic data slightly. But the markets have already priced in falling inflation rates. In addition, the inflation rate is still above the Fed??™s comfort zone, and the central bank has emphasized that the tight labour market poses a risk to price stability. This is also underlined in the FOMC minutes of the October meeting and in the San Francisco Fed??™s latest outlook assessment. So despite the declining price momentum, the Fed has no leeway at the moment to cut interest rates, especially if the economy brightens up.

The latest US economic data have given the dollar a slight boost. However, it remains to be seen how long this can last, particularly in relation to the Asian currencies. On the one hand, solid Japanese GDP growth of 0.5% quarter-on-quarter in Q3 (combined with an upwards revision of growth in Q2 from 0.2 to 0.4% quarter-on-quarter) indicates that an economic upswing is
underway and that the BoJ will therefore keep interest rate hikes on the agenda. On the other hand, there seems to be an unspoken agreement that, in order to unwind global imbalances internationally, the yen should not be allowed to depreciate further. The following all fit into this picture: comments from Europe that the yen reflects Japan??™s (improved) fundamental situation; BoJ governor Toshihiki Fukui??™s warnings about the risks posed by yen carry trades; signs that the Russian and Chinese monetary authorities are planning to stock up their yen reserves, or have already done so. And it goes without saying, that for yen and yuan to appreciate at the same time would be consistent with US policy towards China.

As we had expected, economic growth in the eurozone was up by 0.5% quarter-on-quarter in Q3 (despite weaker results from France and Italy). Compared to the first half of the year, there has been a slight slowdown in momentum, but the pace in Q1 and Q2 cannot be taken as a yardstick for what is realistically sustainable in the eurozone.

However, the development confirms our impression that market participants??™ subjective assessment of growth momentum could be somewhat exaggerated. It is possible that the elation caused by the stock market performance is one reason for this. Although we are also of the opinion that there is reason for optimism, we see the danger of reality not quite living up to the high expectations in the next few weeks, particularly around the end of the year. This could lead to a decline in interest rate hike expectations in the eurozone. The interest rate spread at the short end between the euro area and the USA is slightly in the dollar??™s favour. Admittedly, the BoJ is hinting that it will raise interest rates gradually, but it does not seem to have any firm plans to do so in the immediate future. Combined with the particularly substantial interest rate disadvantage, this would suggest a weaker yen. However, politics (and, in the long term, economic expertise) will probably prevent this. Thus the forex market will continue to be influenced by several contradictory factors.

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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