FX Briefing

Highlights

• Fear of setbacks recedes in the US...
• ...but a sustainable recovery is nowhere near
• ECB dilemma: growth outlook deteriorates, while inflation remains high

Signs of Weakness in the Eurozone

Over the last fortnight, the US dollar has continued to firm slightly. EUR-USD fell to below 1.53 for a time, while USD-JPY traded at around 105 for a few days. From about the middle of the week, when US equity markets began to crumble, the yen started to recover, and the euro followed suit after the ECB Council meeting. At the end of the week, EUR-USD was trading at around 1.5450, and USD-JPY at 103. The dollar has thus come quite a long way since its all-time lows.

The more pro-dollar sentiment is mainly due to market participants currently seeing less risk of the US suffering further economic setbacks. This is evident from the development of credit default swaps and implied volatility on the US equity market: risk premiums have fallen markedly.

The Fed has also played a part by bailing out Bear Stearns, and in addition giving banks and brokers access to the central bank. This has reduced the risk of contagion and of a systemic crisis in the financial system. Furthermore, in its statement at the end of April, the US central bank had no longer spoken of downside risks to growth; markets are taking this as a sign that the easing cycle is coming to an end, which would indicate confidence in the US economy.

The economic data published so far do not give much reason for optimism, however. In the first quarter, GDP growth was 0.6% qoq annualised; thus US GDP has been stagnating for 6 months. Moreover, growth is largely due to stocking up of inventories; this is likely to have a negative effect in Q2. There is no sign yet of things easing on the housing market front. Pending home sales, a leading indicator for existing home sales, plummeted further in February and March, and house prices are continuing to fall too. The April bank lending survey shows much stricter lending standards. Banks are now not just tightening conditions for mortgage loans, but also for corporate loans and credit cards.

Given consumers' high dependency on credit on the one hand, and the significant price increases, particularly for energy, on the other, plus the fall in employment over the last four months, the outlook for private consumption looks far from rosy. The tax rebates, most of which are being sent out in May and June, to the value of around 1% of GDP, are just a one-off. And, according to surveys, only a third of this money is likely to go into consumption. Furthermore, it looks increasingly as if many public authorities, particularly local authorities and federal states, will have to tighten their belts.

In the eurozone, the central bank's dilemma is becoming ever more acute: the inflation rate, which had fallen unexpectedly in April to 3.3%, could even turn out to be somewhat higher again in the coming months due to the recent increase in oil prices. At the same time, however, there are more and more signs that the robust first quarter could be followed by a significant downswing. This has been indicated by company surveys, such as the ifo business climate index, and now "hard" data like German industrial production and industrial new orders as well as retail sales in Germany and the EMU are also showing that the economy is weakening.

Furthermore, the latest ECB bank lending survey shows that credit conditions have tightened significantly in the eurozone too, particularly for corporate loans. Not only are banks demanding much higher risk premiums, but they are more restrictive with regard to volume, collateral and borrowers' other debts. Demand for financing investment in machinery and equipment has dropped markedly, which does not bode well for the economic outlook.

Against a backdrop of growing economic scepticism for the eurozone, it is hard to forecast how market participants will react to the first quarter GDP data, which are expected to be very good. The Bundesbank has predicted growth of about 0.75% quarter-on-quarter for Germany; given the high production increases in the manufacturing and construction sector in particular, it could be even more. On a European level, this figure is likely to be less spectacular at around 0.5% (or slightly higher), but, in the current environment, could be quite positive.

We think it feasible, however, that the Q1 GDP data, which focus on the past, will not have a sustained impact on exchange rate developments. Last Thursday, the ECB confirmed its "wait and see" mode; this can also be taken to mean that it is sceptical as to the economic outlook. We believe that disappointment about further economic development is more likely to come from the European side and therefore the euro will probably tend to be weaker in the short to medium term.

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

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