NEWS / Foreign Exchange

EUR-USD reaches annual high

Highlights

• Equity markets plunge due to problems in the subprime loan sector
• ECB ???still??? unfazed
• Markets hope for support from the Fed

EUR-USD reaches annual high

The turbulence on the financial markets continued this week too. Global equity markets suffered substantial losses again, temporarily falling below the all-time lows reached in the week after 27 February. At the same time, the main funding currencies, the Swiss franc and the yen, rose again versus the high-interest currencies. USDJPY dropped from 118.50 to under 116 ??“ only marginally above the low of 115.15 at the beginning of March. During the course of the week, the dollar recovered somewhat. The movement against the euro was also quite pronounced. EUR-USD continued to gain ground, reaching a new annual high of 1.3323.

The latest slide was triggered by news from the USA. New Century, the second-largest US subprime mortgage lender, got into in financial difficulties after a few large banks had cut off credit. It is now teetering on the verge of bankruptcy. Its creditors include several major credit institutions, thus causing bank shares to slump: many major international banks??™ shares dropped to their lowest levels in months. Investors feared that the problems in the subprime mortgage market could have a more far-reaching effect, as subprime mortgage lending now accounts for about onefifth of the total US mortgage market; in 2002, it was as a mere 5%. Investors??™ fears heightened after the Mortgage Bankers Association reported that default rates in the subprime loan sector had increased sharply, rising from 13.2 to 14.4% in the fourth quarter of 2006.

The problems on the US mortgage market and the corresponding drop in equity prices have prompted investors to reduce risks. Credit spreads widened markedly, and there was increased speculation of unwinding of carry trades,which had a significant impact on exchange rate movements. Central bankers still seem to be quite relaxed about the developments. This applies particularlyto ECB Council members, who see the latest market movements as a useful correction. They are still forecasting sustained robust growth in the eurozone, which, in an environment of ample liquidity, points to upside risks to price stability. This view was also confirmed this week by some research institutes, who revised their growth forecasts for Germany upwards, in some cases quite substantially.

FOMC members could reveal greater anxiety at their two-day monetary policy meeting next week. We expect the FOMC to water down its language even more. It will probably still emphasize the inflation risks, but the problems on the property market are likely to have increased the downside risks to the US economy ??“ particularly as it has not gained much momentum this year. In its latest economic outlook, the Federal Reserve Bank of San Francisco predicts growth in Q1 to be a mere 2%, i.e. just as weak as in the last three quarters. Ex-Fed chief Alan Greenspan also expressed concern that the problems in the subprime loan sector could have a greater effect on the economy as a whole.

There are only a few indicators on next week??™s agenda. However, given the markets??™ nervousness , this does not necessarily mean that it will be a quiet week. The main focus will probably be on the FOMC meeting: as the yield curve in the USA is becoming significantly inverted and 10-year yields are now a good 75 basis points below the federal funds rate, market participants are expecting the Fed to react to the worrying developments on the US property market, at least verbally. If these expectations are fulfilled, the dollar is likely to remain under pressure.