• Overshooting. It is only a question of time before EUR-USD breaches its all-time high at 1.3667. Diverging key rate expectations and the "carte blanche" for FX markets resulting from the G-7 meeting last weekend will see EUR-USD rise even further short term (pages 25-26). Over a medium-term horizon, we would not, however, extrapolate the recent upward trend. Why?
• Correction. A rapid test of the 1.40 mark would result in verbal interventions from politicians, industry associations and ultimately also the ECB. Furthermore, the US economy will gather some momentum during H2 2007. Hence, we expect EUR-USD to stabilize in the summer and pull back again in the course of the second half of the year.
• Impediment to growth? While the recent EUR appreciation is hurting corporate price competitiveness of EMU companies, global trade growth is more important for their exports. Foreign demand is, however, showing no signs of weakness (cf. chart below). The robust economic upswing in the eurozone after the technical dip in the first quarter is, therefore, not at risk (pages 2-4).
• ECB. In addition, the EUR appreciation is making the central bank??™s job easier via its disinflationary impact. It will not, however, slow or even stop the ECB??™s tightening cycle. Excessive liquidity as well as growing inflationary risks as a result of rising oil prices and higher wage settlements will prevent this.

Further topics:

• Italian GDP: Hardly any growth in the first quarter (page 5).
• US consumption: Normalization, but no slump (page 7).
• Bank of England: A May hike is a done deal, further tightening a risk (p. 11).
• Industrial metals: Supply shortages keeping prices high (page 13).
• Data outlook: Robust Ifo reading; Q1 US GDP growth below 2% (page 16).
• Market outlook: EUR to test new highs; breather for govies (page 24).

WILL THE SOARING EUR STOP THE ECB?

• The euro has the 2004 highs firmly in its sights. Will this trigger a slump in foreign demand? We don't think so.
• Even though the strong EUR is hurting corporate price competitiveness, global trade is more important for exports. And it continues to post brisk growth.
• Since the pace of the EUR appreciation is also slower than in 2004, the ECB has so far not voiced much concern. As a result, an end to the tightening cycle should also not be expected any time soon.

EUR APPROACHING TO THE 2004 HIGH

Interest is again focusing on the external value of the EUR. Against the JPY, the EUR is posting new alltime highs on an almost daily basis, and against the USD the all-time high of 1.3667 posted in December 2004 is also within reach. Will the appreciation of the EUR therefore crimp exports as in 2005? While there is no doubt the deterioration in the price competitiveness will hurt sentiment in the exporting sector, there is, nevertheless, still no reason for excessive pessimism.

FOREIGN DEMAND IS NOT COLLAPSING

Recently, the EUR has appreciated not only against the key global currencies ??“ the USD and JPY ??“ but also against a number of other currencies. The trade-weighted external value of the EUR calculated by the ECB (versus the 24 most important trade partners) is, therefore, also only just shy of its alltime high (cf. chart).

There is, however, no evidence of a strong correction in foreign demand because of the strong EUR. First, corporate price competitiveness on export markets is determined not only by the exchange rate but also by the relative development of unit wage costs. Since unit labor costs in the eurozone increased at a slower pace in 2005 and 2006 than in the economies of its trading partners and since no strong acceleration is expected this year either thanks to good productivity growth, the appreciation of the EUR in real terms is more moderate (cf. chart).

Accordingly, based on the EU Commission survey, companies think that their competitive situation on sales markets is still good. In the first quarter, the corresponding index for manufacturing was still considerably above its long-term average (cf. chart).

STRONG GLOBAL TRADE DRIVING EXPORTS

Second, the economic development abroad is much more important for export demand than the exchange rate. Econometric calculations of the EU Commission confirm this.1 They show that a 10% appreciation of the real effective exchange rate slows the exports of goods and services by only just over 2%. In contrast, a 10% decline in global import demand would lower eurozone exports by roughly 8%. So far, however, global import demand and global trade are showing only few signs of a slowdown and they are, therefore, stabilizing exports from the eurozone (cf. chart).

To this extent, it is also not surprising that sentiment in exporting industry is still outstanding. According to a survey of the EU Commission, the assessment of foreign order backlogs in the first quarter rose to a new record high. The expectations for export volumes are similarly positive (cf. top chart next column).

PRESSURE ON MARGINS RISING, BUT NO SLUMP

It is, however, possible that the good order situation in the exporting sector was ???bought??? with lower prices and, therefore, lower profit margins. This would be the case if export prices decline or at least rise more slowly than unit labor costs. One example of this was the development in the years 2001 to 2004 (cf. bottom chart next column). At that time, export prices fell while unit labor costs rose.

Since 2005, export prices have again risen much more strongly than unit labor costs, an indication of rising profit margins in exporting industry. In any case, there are so far no indications of a slump in profit margins.

STRONG EUR SUPPORTING DOMESTIC ECONOMY

Of course, a strong currency has not only negative but also positive implications for the economy. The appreciation of the EUR is lowering the import prices of capital, consumer and input goods. Over the medium term, lower import prices also have a positive impact on consumer prices. This increases household purchasing power and, therefore, boosts domestic demand. The chart below illustrates this correlation. In the last 10 years, an appreciation of the trade-weighted EUR went hand in hand with falling import prices. It is only recently that the correlation appears to have weakened for some product groups. The sharp rise in prices of intermediate goods despite the EUR appreciation is, for the most part, the result of the rise in commodity prices.

ECB NOT CONCERNED SO FAR . . .

All this explains why the ECB so far has been very laid back concerning the appreciation of the EUR. There is much to suggest that export growth will remain dynamic (cf. chart).

Dutch central bank president and ECB Governing Council member Nout Wellink even said last week, "a strong EUR is in Europe??™s interest ". At the G-7 meeting last weekend, there were also no clear warnings from central bank governors and finance ministers concerning the ongoing weakness of the JPY and USD versus the EUR. From the ECB??™s standpoint, a strong EUR is only a problem when: 1) the appreciation is very rapid with the result that exporting companies cannot react in their price calculations, and 2) the appreciation triggers a rapid deterioration in sentiment in manufacturing. Both are currently not the case in contrast to the EUR appreciation in the second half of 2004. At that time, the ECB spoke of "strong vigilance" with respect to future price dangers in its press releases. But the rapid EUR appreciation and the slump in the sentiment indicators in the following months prevented the start of the tightening cycle. The ECB President said in November 2004 that "brutal" changes in the exchange rate are "not welcome".

. . . AND THUS REMAINS ON TIGHTENING COURSE

So far, therefore, it is not expected that the ECB will end its tightening soon because of the EUR appreciation, even though the EUR appreciation is tightening monetary conditions. The appreciation of the real, trade-weighted exchange rate since the beginning of the year translates into monetary policy tightening based on real 3M interest rates of roughly 30 basis points.3 Since, however, the economic sentiment indicators and the key liquidity numbers at the beginning of the year were higher than expected, the ECB remains clearly on course.

However, the wait-and-see stance of the ECB with respect to the current EUR appreciation also harbors risks. Market players could interpret this as a "license" for further currency speculation. The upshot would possibly be a rapid overshooting by the EUR exchange rate. If the EUR-USD exchange rate were, therefore, to rise rapidly but above all on a sustained basis above 1.40, this would endanger our ECB scenario of three more rate hikes, bringing the refi rate to 4.50% at the end of 2007.