ECB interest rate hike has become more likely

Highlights

Euro soars to over 1.45 after Fed rate cut
Rising inflation in the eurozone puts ECB in a quandary
Markets toy with the idea of the HKD giving up its US dollar peg

ECB interest rate hike has become more likely

Yet another record has been broken: on Wednesday evening after the Fed??�s interest rate cut, EUR-USD surged over 1.45 for the first time ever. However, markets had already firmly priced in the US interest rate cut to 4.50%. The dollar was also supported by the fact that the Fed??�s statement attempted to dampen hopes of further interest rate cuts and that US Q3 GDP and labour market data (ADP index) had turned out unexpectedly positive. Thus the euro only remained over 1.45 for a short time.

But at around 1.4480, EUR-USD is set for a sustained rise above 1.45. US economic data are very mixed at the moment, and the equity market, financials in particular, plummeted on Thursday. The calming effect of the interest rate step did not last long. However, the ECB could give the euro fresh impetus too. The ECB Council is holding its monthly meeting next Thursday. The acceleration in consumer prices in October and the recent surge in the price of oil and other commodities are likely to be a worry to the Council members.

The yen continued to mirror the development of the equity markets; there is a very close correlation between USD-JPY and EUR-JPY exchange rate movements and US equity indices. Stock price gains are a sign of growing confidence and increase risk appetite. Accordingly, the yen is sold in favour of currencies with high interest rates, and/or those with higher-yield potential. If, on the other hand, equities fall, investors stock up on yen. Following this pattern, by Thursday USD-JPY had risen to almost 116, and EUR-JPY to over 167. Parallel to the setback suffered by equity markets, the yen subsequently recovered to 114.70 and 166.00 respectively.

Hong Kong sticks to Currency Board It is interesting to observe how the Hong Kong dollar is developing. Currently, the HKD is firmly pegged to the US dollar via a currency board, at a parity of HKD7.80 to one US dollar, with a fluctuation range of 5 cents. Strong inflows of funds particularly into Hong Kong??�s equity market (which is used by many Chinese firms for IPOs) pushed the HKD down to the lower end of the trading range (HKD7.75) at the end of October. At the same time, due to the higher liquidity, money market rates fell well below equivalent US rates. Thus the HKD forward rate was quoted outside the trading range. The forex market is now presuming that the currency board system is on the verge of collapse and that the HKD will appreciate. The idea of the Hong Kong dollar giving up the US dollar peg and linking to the renminbi instead, has cropped up every now and then, especially when the pace of renminbi appreciation accelerates, as it is doing now.

However, Joseph Yam, the head of the Hong Kong Monetary Authority, has officially denied all plans to give up the present system. We consider this announcement credible, because as long as international capital transactions with the People??�s Republic of China remain strictly regulated, a link between the two currency areas would be extremely problematic for Hong Kong??�s economy. Hong Kong will probably be integrated in the long term, but for the time being, it would be neither in China??�s interests nor in Hong Kong??�s.

ECB: inflation worries increasing

In October, inflation in the eurozone accelerated unexpectedly sharply from 2.1 to 2.6%. Detailed data are not yet available, but higher energy and food prices are probably the main reason for this. Unless energy prices correct significantly in the near future, consumer price increases are likely to be higher than average in November, and possibly in December too. Consequently, there is a danger of the inflation rate approaching 3% in the winter months.

The ECB Council bases its oil price forecasts on Brent forward prices. Admittedly, prices for 2008 delivery are showing a slight decline as the year progresses, but the market still expects an average oil price of over $86 for next year. The ECB??�s September projections had been based on $72 only. The appreciation of the euro is dampening prices to some extent; at present, about 5% compared with September. The ECB staff is moreover likely to reduce its growth expectations slightly. Somewhere in the vicinity of the IMF??�s forecast of 2.1% would be conceivable. However, at best, that would help to lower inflationary pressure in the long term. All in all, it looks as though the ECB will raise its inflation forecast for 2008 significantly in December, from 2.0 to about 2.3%.

Although the ECB might not meet its price stability target in 2008, this does not automatically mean that interest rates will be raised. But it is becoming evident that at least a few hawks in the ECB Council are tending towards a more restrictive interest rate policy. At next Thursday??�s meeting, the central bankers will therefore probably step up their inflation risk warning considerably. However, in view of the uncertainty in financial markets and the ensuing risks to further economic development, the ECB is not likely to signal an interest rate step in advance, by using the term strong vigilance, for example. Nevertheless, given the present economic environment, we think that an interest rate hike is the most likely option in December, when the ECB??�s new projections are due to be published.