• Markets are pricing in too many cuts in US interest rates

  • Swiss franc under appreciation pressure

US dollar

The EUR/USD exchange rate fluctuated within a narrow bandwidth around 1.46 in the past few weeks. The reason for the sustained low level of the USD was the fears regarding the further effects of the subprime crisis on the financial markets and on the entire economy in the US. The US indicators released pointed to a sluggish economy, but there were no indications of a recession.

Thus, we view the market’s expectations regarding the pace and magnitude of further interest rate cuts as exaggerated. In contrast to the market, we do not expect any further interest rate cut this year, but rather in 1Q 2008. The market is pricing in around interest rate cuts of 50 bps more until mid-2008 than our estimate for a key lending rate of 4%. The reasons for the more aggressive expectations are to be found less in the concrete data, but rather in the high degree of insecurity prevailing in the US at present. Granted that it is correct that no one is able to assess how many skeletons are still hidden in the closets of US financial institutions and how far the correction on the housing market will go and how large the entailing impact on other sectors of the economy will last. At present the market is pricing in an extremely negative scenario that even though it cannot be ruled out, in our view, it carries a relatively low degree of probability. Of course, there will be more write-offs of subprime financial securities. At the same time, the losses obviously do not affect US banks too severely, as bonus payments of major investment banks for the current business year will be increased. The expected decline of home prices is bound to have a negative influence on consumer spending. Still, the positive wage development should be able to compensate quite a bit of it. All in all, we expect a bout of weakness of the US economy that will trigger interest rate cuts far into the year 2008. But the scenario for the economy and interest rate developments currently priced into the market are improbable in our view, and we accordingly assess the USD as undervalued.


Swiss franc

The Swiss franc came under some strong appreciation pressure in the past few weeks. The renewed rise of risk premiums on bonds and the correction on most stock markets triggered a reversal of the franc after it had hit a low again in October at 1.68 EUR/CHF. The franc even managed to firm more than the Japanese yen, which indicates a general increase in the level of risk aversion. Apart from heightened volatility on financial markets, this was probably also encouraged by the insecurity regarding the further course of the USD and the massive rise of the oil price. Over the medium term, we expect the franc to continue to gain against the euro and return to the old bandwidth between 1.50 to 1.60 EUR/CHF.

As regards the further course of interest rates, we perceive a close relationship between the respective exchange rate trend and key lending rates. The firmer the franc, the less probable further rises in interest rates seem. As the current level of 2.75% may already be viewed as neutral for the 3M CHF Libor, the Swiss National Bank now has relatively wide scope for manoeuvring. Should the franc continue to rise steeply, there is not much reason for further interest rate hikes, but should the franc rise only gradually until the first quarter of next year, we expect a further interest rate hike to 3%.


Yen

After the second attempt to drive the euro to a new high vs. the yen failed, a hefty substantial countermovement set in. A major reason was probably, above all, the weakness of the US stock market. Together with the imminent end of the year, this probably resulted in the closing out of carry trades, in this case the closing of positions financed in yen. A clear sign of the nervousness on the markets was that the yen broke through an important technical barrier vs. the US dollar and hit an 18-month high.

Of all of the economic data released in Japan, GDP for 3Q must be highlighted. Versus the preceding quarter, growth was 0.6% according to this first estimate. The corresponding figure for the previous quarter was revised slightly downwards, but overall, it was still a positive surprise. On the average of the two quarters, the growth rate reported was low, but still positive. On the same day as 3Q GDP was released, the Bank of Japan took its interest rate decision. As expected, interest rates were left unchanged despite the good economic development in 3Q. A major reason was definitely the insecurity regarding the further course of the US economy. Moreover, the inflation rate continues to fluctuate around 0%. At the preceding meeting, Governor Fukui stressed the need for adjustments to Japanese interest rates and for this reason we expect an interest rate hike at the beginning of next year. The persistent insecurity on the financial markets is believed to be much more important for the short-term development of the yen. Together with the generally nervous mood that prevails around at the end of the year, this might result in the closing out of more carry trades and thus cause the yen to rise precisely in the coming weeks. A countermovement would definitely follow. However, we believe that the trend reversal of the EUR/JPY has started and the high was seen this summer at 169.