NEWS / Foreign Exchange

EUR-USD set to break the record

• Euro climbs further to over 1.36; all-time high within reach
• US inflation fears abate after benign core CPI
• Accelerating inflation in the UK pushes Sterling above $2
• Equities wobble on concern about impending tightening measures in China

EUR-USD set to break the record

During the course of the week, the euro continued to strengthen slightly. Early Friday morning EUR-USD reached 1.3637. Thus December 2004??™s all-time high is gradually coming closer. The yen firmed significantly at first, but relinquished some of its gains again towards the end of the week: USD-JPY fell below 118 temporarily, but ended the week at 118.7; EUR-JPY dropped to below 160, but recovered to 161.5 on Friday. The pound Sterling??™s movements were also remarkable. After the release of unexpectedly high inflation data, Sterling wet above USD2.00 for the first time since September 1992, when it was catapulted out of the EMS. EURGBP fell initially, but soon rallied again, and, at just under 0.68, has now returned to the previous weeks??™ level.

US economic data published this week were mixed once again. Whereas retail sales turned out unexpectedly positive, the results of the New York and Philadelphia Fed surveys in the manufacturing sector were weak. The housing market figures showed no sign of improvement either. Core CPI was the most significant figure. It increased by less than 0.1% because owners??™ equivalent rent and medical care costs levelled off. Against the background of these figures, inflation rates on the basis of the core PCE deflator could slow down from 2.4 to 2.2 or even 2.1. This would give the Fed scope to cut interest rates, particularly given that central bank representatives had in the last few weeks voiced doubts as to whether inflation would moderate sufficiently.

Theoretically, a higher probability of US interest rate cuts should boost the euro and the yen equally. But in fact, the euro gained far less than the yen. Presumably the yen movement was strengthened by investors unwinding carry trades. In the run-up to the G7 meeting of finance ministers and central bankers, there had been an increase in speculative positions, and Asian equity markets and typical target currencies such as AUD and NZD had made substantial gains. Bearing in mind that the economic environment has become altogether more risky on account of the weak US economy, investors are likely to have been keen to take profits.

There was additional impetus for the yen and increased pressure on equity markets from China. According to Chinese sources, real GDP rose in the first quarter by 11.1% year-on-year ??“ again much more rapidly than the government would like. The reference value is actually at 8%. Furthermore, inflation accelerated in March from 2.7 to 3.3%, mainly due to higher food prices. The data fuelled anxiety that the government could impose new restrictive measures ??“ including interest rate hikes ??“ in an attempt to stop the economy from overheating. This caused a slump on the Chinese stock market. At close of trading, the CSI 300 Index had dropped by 4.7%. The stock market??™s reaction was probably aggravated by the unexplained delay of several hours in releasing the data, and a statement by Prime Minister Wen Jiabao announcing stricter measures to control investment activity and lending, and to reduce the trade surplus.

At the moment the appreciation of the yen and the slump on Asian stock markets just looks like a blip. The yen has relinquished practically all its gains again, the Asian and European equity markets have now returned to about the same levels as at the beginning of the week. In our view, however, the development illustrates the inherent risks on the financial markets at present: if the US economy weakens and interest rate cuts become more likely, the basis for carry trades starts to wobble too. This week??™s events will repeat themselves.

For the time being, EUR-USD will remain wellsupported due to the diverging growth prospects in the USA and the eurozone. Economic data due to be released next week are more likely to strengthen hopes for the euro: the ifo business climate index for April could remain on its high level, thus underpinning the optimistic forecasts for Germany and the euro area. On the other hand, expectations for US growth in the first quarter are low. This is not a bad basis for topping the previous record.