FX Briefing

Highlights

• EUR-USD hits 1.47 temporarily
• Necessary adjustments to US current account balance call for weak dollar
• ECB will soon have to face the facts: growth collapse will be even more dramatic

Dollar Collapse at the End of the Year

The dollar has continued to plummet. Last week, EUR-USD rose by about 5%, and this week, the European currency has climbed further, gaining almost 5% to around 1.40. It even reached a peak of 1.47 temporarily, but profit taking then set in. Most other currencies posted gains versus the dollar too: the Swiss franc was this week's winner with an increase of around 7%; the yen also rose by about 2%; the pound however only managed a minute gain of 0.1%.

The dollar's marked losses are a correction: in our opinion the greenback's earlier gains - the result of dollar-oriented investors abruptly turning their back on risky assets after the Lehman collapse in a rather illiquid market - were exaggerated. Without easy access to credit and without the boost from rising property prices, private consumption in the US is likely to be much more sluggish than in the past. Thus the savings rate is rising. When on the one hand private households save more, that means that on the other hand either companies have to invest more or the state and the external sector have to save less. But US firms are likely to remain reluctant to extend their capital stock for some time. The US government is in fact spending massively and raising the budget deficit. But the state cannot permanently fill in for lacking private sector demand. So in the end the external sector (the foreign trade partners of the US), will have to reduce their savings, i.e. net exports. This in turn speaks for a weak dollar.

Of course it is not possible on the basis of these fundamental reflections to make an accurate exchange rate forecast. A EUR-USD rate of around 1.25 - which from a purchasing power parity point of view could be regarded as more or less "neutral" - is likely to be too low, however. Rates of around 1.40 or 1.50 are probably more realistic.

The dollar's slide was presumably triggered by monetary policy. In the run-up to the FOMC meeting, markets had already been speculating on a further interest rate cut, but then the aggressiveness of the Fed surprised even hard-boiled observers: the US central bank wants to keep overnight rates in a range of 0 to 0.25%; this is practically zero interest rate policy. Moreover, it says it is likely to keep interest rates at this exceptionally low level for some time to come. The Fed is thus making a commitment for the future. And finally, it is pledging to support credit markets and economic activity through quantitative easing.

The Fed's course of action is quite the opposite to that of the ECB. ECB representatives reiterated this week that they are not expecting any monetary policy changes at the January meeting. Furthermore, they are emphasizing that the loose policy will have to be corrected as soon as possible. And they have also made bond markets nervous by declaring that EU states which get into financial difficulties should not be bailed out by other member states. Such utterances are cancelling out the effectiveness of the rate cuts implemented.

We are, however, still convinced that the ECB will soon have to face the facts. It already looks as though the 2009 growth forecast made at the beginning of December is unrealistic: according to press reports citing government sources, the German economy shrunk by 1.25 to 1.75% in the fourth quarter; should that turn out to be correct, a GDP decline of "only" 2% in 2009 would be rather optimistic. However, it looks very much as though the contraction will continue in the new year; the business climate and industrial new orders have deteriorated drastically. Thus the slump will probably be even worse in Germany - more in the range of 3 to 4%. This would mean that the ECB forecast of -1 to 0% for the eurozone is completely unrealistic.

We are therefore expecting the ECB to resume cutting interest rates in the new year - if not in January, then all the more drastically in the following months. Once the ECB starts shifting towards a more aggressive policy like the Fed and other central banks, the euro could suffer temporarily, particularly if this coincides with bad economic data from the eurozone. However, we see EUR-USD above 1.40 in the longer term.

BHF-BANK
http://www.bhf-bank.com

This report has been prepared by BHF-BANK Aktiengesellschaft on behalf of itself and its affiliated companies (together "BHFBANK Group") solely for the information of its clients.

The information and opinions in this document are based on sources believed to be reliable and acting in good faith, but no representation or warranty, express or implied, is made by any member of the BHF-BANK Group as to their accuracy, completeness or correctness. Opinions and recommendations are given in good faith but without legal responsibility and are subject to change without notice. The information does not constitute advice or personal recommendation, for which the duty of suitability would be owed, but may facilitate your own investment decision. Moreover, you should seek your own advice as to the suitability of an investment matter mentioned herein. Investors are reminded that the price of securities and the income from them can go down as well as up and that the past performance of an investment or a market is not necessarily indicative for future results.

This document is for information purposes only. Descriptions of any company or companies or their securities mentioned herein are not intended to be complete, and this document is not, and should not be construed as, an offer to sell or solicitation of any offer to buy the securities mentioned in it. BHF-BANK Group and its officers and employees may have a long or short position or engage in transactions in any of the securities mentioned in this document, or in any related securities.

This publication must not be distributed in the United States.