FX Briefing

Highlights

• ECB sees no reason for further interest ratehikes for the time being
• EUR-USD falls to about 1.57 after dovish ECB press conference
• Oil price development influences exchange rate, not vice versa

ECB in Wait-and-See Mode

Last week the Open Market Committee published a statement, which was seen by the markets as being on the dovish side. Subsequently, with the impending ECB Council meeting in mind, the market began to trade on the idea of a dovish Fed versus a hawkish ECB. The fact that the oil price soared to about $145 per barrel and inflation in the eurozone accelerated more sharply than expected to 4% fuelled the notion of the ECB taking a more hawkish stance. This idea was reinfoced by the Swedish Riksbank not only raising interest rates as expected to 4.5% on Thursday, but also signalling further rate hikes (plural!) in the second half of the year.

On the US side, the main impetus came from the weak equity markets. Amid numerous reports and rumours about fresh crises in the banking sector, record high oil prices and abysmal vehicle sales figures, equity markets continued to plunge. But another reason why markets were nervous was probably the impending US labour market report; all the signs, which were then for the most part confirmed by the actual results, had been extremely negative.

Against this backdrop, the interest rate spread between Bunds and Treasuries (2-year) widened by about 35 basis points to almost 220 points by Thursday. EUR-USD firmed to 1.59, rising to the highest level for over two months. If the ECB had been hawkish enough and the US labour market report had turned out to be really bad, the euro would probably have climbed even higher, possibly over 1.60.

After the Tankan, which showed signs of weakness, but not as bad as markets had been expecting, USD-JPY fell briefly to 105, only to strengthen again to around 106. Formerly, the yen always strengthened in times of increasing economic uncertainty (weak equity markets, widening credit spreads), but the correlation is no longer as close as it used to be.

On Thursday, however, markets got a surprise: the ECB did raise interest rates to 4.25% as expected, but explicitly refrained from giving any indication as to future interest rate policy. The statement merely said that the interest rate decision would contribute to achieving the objective of price stability; the bank would continue to monitor all developments very closely. Jean- Claude Trichet said he had no bias on interest rate policy. Nor did he give any indication of differences of opinion within the committee.

The ECB, of course, emphasized the increasing upside risks to price stability again, and warned particularly of the danger of second round effects from higher wage agreements. However, the ECB now seems to be expecting a sharper growth slowdown. The positive factors, such as employment growth, robust growth in emerging markets and tight production capacity would presumably no longer be able to counterbalance the burden, which higher energy and food costs are placing on purchasing power. The ECB has not signalled any intention of raising interest rates further in the next few months. If, as we believe, economic concerns are confirmed during this time, inflation will be controlled increasingly via the demand side; interest rate hikes might therefore no longer be necessary.

Oil and the dollar

The connection between the oil price and the dollar exchange rate is turning into a neverending story. Falling dollar goes hand in hand with a rising oil price and the correlation has been particularly strong since autumn 2007. But this does not shed any light on the question of whether oil moves the dollar or the dollar moves oil.

During the last few weeks, there has been a lot of discussion as to whether the ECB's rate hike plans would push up the oil price even more. The reason given was that the higher central bank rate in the EMU would lead to a depreciation of the dollar and this in turn would make the oil price rise – in a way, as compensation for the loss of purchasing power of the dollar-denominated oil revenues.

However, this theory is a bit shaky. The oil price movements have typically been much more pronounced than the exchange rate movements. A simple regression of the daily changes shows a beta of about 1.5. This can hardly be explained by the compensation argument. Furthermore, it is not really plausible that a restrictive monetary policy in Europe, which would in fact curb demand, would push the oil price up. However, in the short term, the oil price can react to movements on the foreign exchange market, simply because the correlation is firmly lodged in market participants' minds.

It is more likely to be the oil price which is affecting the exchange rate, rather than the other way round. Rising oil prices lead to higher current account balance surpluses and larger dollar holdings in the oil producing countries. This in turn makes investors look to diversify out of the dollar into other currencies. Moreover, the rising oil price is a growth risk to industrialized countries. The dollar has been the most obvious candidate for depreciation up to now, as the US economy is suffering as a result of the housing market and credit crisis, and the Fed has cut interest rates significantly. Due to the depreciation risk, surplus countries are likely to have increased their efforts to reallocate their mainly dollar-denominated funds.

The ECB's relatively restrained stance will probably tone down the contrast between the monetary policies of the Fed and the ECB to some extent. Thus, given the current level of EUR-USD, and taking our sceptical assessment of the European growth outlook into consideration, we see very little appreciation potential for the euro; rather the opposite. If the oil price falls at some point, it is more likely to be as a result of the global economic slowdown rather than the EUR-USD exchange rate.

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

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