NEWS / Foreign Exchange

Euro heading for new heights

Highlights

• EUR-USD climbs above 1.35; all-time high of 1.3666 in sight
• ECB signals intention to raise interest rates in June
• US economic data will continue to burden the dollar for the time being

Euro heading for new heights

The euro is continuing to climb. After the ECB meeting the single European currency rose to over 1.35 against the dollar ??“ the highest rate since the end of 2004. Thus December 2004??™s all-time high of 1.3666 is in sight again. In relation to the yen, the euro has already left any such landmarks far behind; here the euro hit the 160 mark this week.

By no means all the European economic indicators published in this short Easter week were favourable. Although French industrial production increased unexpectedly strongly in February, the corresponding figures from Italy were rather disappointing. Furthermore, the German trade figures for January and February suggest that the export side could dampen Q1 growth significantly. We are thus sticking to our view that EMU growth in Q1 will probably be much lower than in the previous quarters ??“ 0.5% at the most.

But the forex market was unfazed by this. Its main concern is economic growth in the eurozone remaining sound in the medium-term. And indeed, institutions and institutes have rarely been so unanimous. The ECB forecasts 2.5% growth for 2007, the EU commission 2.4%, the IMF 2.3%, and the European economic research institutes cooperating in the Euroframe network forecast 2.5%. Moreover, the mood in European equity markets continues to be optimistic. The overriding impression is that, compared to the USA and Japan, the European economy is facing the least economic risks.

The ECB governing council, which held its regular meeting last Thursday, is in no particular hurry to raise interest rates; however, the emphasis on the upside risks to price stability, the statement that monetary policy is still accommodating, and also Jean-Claude Trichet??™s comment on the markets??™ expectations for June, all signal that the refi rate is likely to be raised again in early summer.

Due to the economic prospects and the central bank??™s tightening bias, the euro is currently the most popular of the major currencies. With the dollar, there is the risk that the pressure from the housing market could bring the US upswing, which is past its prime anyway from a cyclical point of view, to an end. In addition, due to the sustained high US current account deficit, there is a latent necessity for the dollar to depreciate; with a view to China, this is even politically opportune. Even the Europeans have admitted in the G7 statement that a controlled depreciation of the dollar is necessary in order to correct global imbalances.

The biggest burden on the yen is the fact that the BoJ has limited scope to raise interest rates: on the one hand because price development is still very close to deflation, and on the other because the BoJ is under considerable pressure from the government. Moreover, the two new members of the BoJ Council do not really seem to be hawks. Besides, export-driven Japanese growth is widely thought to be more dependent on a healthy US economy than European growth is.

In the short term, we are not expecting any change in the current pro-euro trend. The forthcoming European economic indicators are not likely to darken the positive picture much. In contrast, US economic data in the coming weeks will probably continue to be on the weak side. We are only expecting a modest result for retail sales, particularly if the gasoline price effect is not included. The figures will probably highlight the weakness in consumer spending. March industrial production is not likely to be all that good either, due to utilities??™ weather-related negative impetus, weak auto sales and a declining ISM index. Because of full inventories, the New York and Philadelphia Fed??™s April surveys in the manufacturing sector are unlikely to be any brighter. And looking slightly further ahead, attention is now turning to GDP data for the first quarter, due to be published on 27 April. The consensus forecast is currently just scraping 2% (annualised) quarteron- quarter. That might be sufficient growth for the Fed to postpone interest rate cuts. However, it is not the stuff that dollar dreams are made of.