FX Briefing

Highlights

• Short-term yields rise significantly, but with little effect on the forex market
• Strong German growth in Q1 drives EMU growth, outlook for Q2 negative
• US, EMU and Japanese central bankers are cautious as to growth outlook

Dollar Lacks Direction

Once again, bond markets priced in substantial interest rate hikes in the USA and scaled back expectations of interest rate cuts in the eurozone: during the course of the week, yields on 2-year Treasuries rose by about 30 points to 2.50%, yields on German 2-year notes also climbed by 30 points to about 4.00%. The bond markets thus reacted quite selectively to remarks made by certain central bank representatives - by Sandra Pianalto from the Cleveland Fed, for instance - and to a further surge in oil prices. Initially, the spread narrowed by more than 15 points in favour of the US bonds, but widened again in the latter half of the week to over 150 points. However, despite hefty interest rate movements, the forex market lacked direction for the most part.

US economic data did not give any clear signals, but as equity markets were performing favourably, they tended to be interpreted positively. In contrast to this, the unexpectedly robust growth figures from the EMU and Japan prompted a more cautious reaction. The central banks were presumably partly responsible for this. ECB president Jean-Claude Trichet, for instance, emphasized that growth was likely to slow down during the course of the year. He thus made it clear that the recent data would not change the ECB's policy stance. The situation was similar in Japan: there, only last week, the BoJ had revised down its growth forecast and deleted the remark that it was basically prepared to raise interest rates. Thus hawkish hopes were dashed right from the start.

This week EUR-USD moved in a trading range of about 1.5450 to 1.55. The euro closed the week at 1.5460 - basically unchanged from the previous week. In contrast, the dollar rose slightly against the low-yield currencies JPY and CHF. After a brief phase of weakness at the end of last week at around 103, USD-JPY climbed to almost 106 for a short time. However, the dollar's ascent was cut short, presumably due to Japanese GDP data for Q1; USD-JPY ended the week at around 104.70. USD-CHF improved to over 1.05 - just shy of its “post Bear Stearns” record highs. Cable did not recover any ground either, despite the acceleration of inflation in the UK and the inflation report which was perceived as hawkish; GBP-USD remained more or less unchanged at around 1.95. Some emerging market currencies firmed, which can be taken as a sign that risk appetite is growing: the Turkish lira, the rand, and the real all rose quite significantly during the course of the week, and so did the forint.

German GDP: good and bad

The notion that Q1 European GDP data might surprise on the positive side was more than confirmed. According to preliminary estimates, German GDP grew in real terms by 1.5% quarter on quarter, the highest quarterly growth rate since 1996. A more detailed breakdown of the figures has not yet been published, but investment in machinery and equipment and construction investment in particular are likely to have had the biggest impact. Production statistics show that building activity increased by over 10% in Q1.

Inventories were probably stocked up significantly too. Private consumption, however, seems to have remained subdued, and net exports made a negative contribution.

Given the strong start to the year and an overhang from the previous year, annual average German growth in 2008 would probably still be robust, even if the German economy were to slow down in the coming quarters. In the event of stagnation in the next three quarters, GDP growth would still reach 2.5%.

We should, however, brace ourselves for a significant slowdown in economic activity in the second quarter at least. Real retail sales did not get off to an easy start in Q2, and the ifo business climate data show that the situation in the retail trade deteriorated further at the beginning of Q2. A sharp turnaround is also evident in the building sector, where production in March was almost 8% below the average for Q1 - the worst possible start for Q2. Moreover, the ifo data for the construction sector in Q1 and the beginning of Q2 do not show fluctuations like the production data. This suggests that construction's large contribution to growth in Q1 might have been a statistical chimera, presumably partly due to favourable weather conditions. A setback in the second quarter is therefore inevitable.

There is very likely to be contraction in Q2. Against a backdrop of soaring energy prices, the strong euro and decelerating global economic momentum, the slowdown could well continue in the second half of the year. Technically, there could quite possibly be a recession in Germany. Growth in the whole of the eurozone was 0.7% quarter-on-quarter in Q1, after 0.4% previously. Germany alone contributed more than half, 0.4 points, to growth in Q1; Germany and France together accounted for over three-quarters.

Growth in other countries, particularly Spain, the Netherlands, Portugal and Belgium, was below average. Due to methodological changes, Italy has for some time been a white spot on the statistical map. The indicators which are available tend, however, to be more on the weak side.

Therefore, if German growth were to plummet in Q2, the eurozone economy's main pillar would collapse. In view of this, it is quite understandable that the ECB representatives are exercising a great deal of caution in assessing the good Q1 growth data.

BHF-BANK
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