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ECB and Fed disappoint interest

Thu, Jul 10 2008, 11:12 GMT
by Erste Bank Bond Research Team

Erste Bank der oesterreichischen Sparkassen AG

• Franc moves sideways – SNB in a conflict

• Yen in sideways channel close to low – until when?

US dollar

The latest interest rate decision-making meetings of the US Fed and of the ECB caused some movement in the forex markets. The two central banks still disappointed market participants speculating on future interest rate hikes and the EUR/USD is hovering around 1.56 now. Neither did this change after the ECB raised key lending rates in contrast to the Fed. The markets had been expecting the move and therefore it did not trigger any reaction.

However, uncertainty prevailed over how far it would go. ECB President Trichet made it clear that no one was thinking of any further interest rate hikes for now. The inflationary risks were communicated again, of course, stating that there was no need for further measures now though. Thus, there is no basis for interest rate speculations at least until the next meeting of the ECB Council. Neither do we expect any further interest rate hikes in the following period. The inflation rates will remain high for the time being, but the weak economic data will have a compensatory effect from a monetary policy perspective. The situation in the US is similar, we expect a mix of high inflation rates and weak economic indicators here in the coming months too. This will fuel at the most short-lived interest rate speculations. Overall, we expect an unchanged US key lending rate, at least until year-end. The only thing that might change this would be a drop in the price of the USD. This would raise inflationary pressure because of higher import prices and due to the probable concurrent increase in the oil price. Neither is Euroland interested in a weak USD. Therefore, should the EUR/USD rise quickly above the mark of 1.6, this would trigger either interventions by one or several central banks in favour of the USD dollar or higher US interest rates.

Swiss franc

The rise in inflation up to now is making the SNB worry about second-round effects after all. Thomas Jordan announced in an interview on Sunday that the SNB would react mainly to indications of higher wage demands and in such case might lift interest rates. Like in all industrialized countries, the high oil price has resulted in lower incomes for Switzerland versus (oil-exporting) foreign countries. According to Jordan, this loss of income has to be distributed among businesses and employees, because otherwise higher wages could lead to higher demand, hence higher prices. At unchanged wages and a stable oil price, the SNB expects a decline in inflation due to slower growth and does not perceive any reason to raise interest rates in this case.
On the other hand, a revival of the credit crisis would rule out a restrictive monetary policy, i.e., higher interest rates. The credit crisis is not having any effect on the real economy (no bottleneck in lending by banks to customers has been seen), but the consequences of a default of one of the major banks would be considerable. UBS was downgraded last Friday by Moody’s rating agency and is expected to reach a balanced result this year only due to a tax credit of around CHF 3bn. The SNB is therefore in a severe conflict situation. The next movement is expected to be a hike in the key lending rate, but when this move will be made depends largely on the development of wage demands and also on the development of the banking crisis. The Swiss franc is accordingly moving sideways and is currently “caught” between the banking crisis and inflationary expectations.

Yen

The yen remained near its all-time low versus the euro. This movement caused by the higher interest rate spreads has only little to do with the real economy. Extremely low interest rates in Japan are leading to a situation in which loans are taken out in yen in order to invest the money more profitably elsewhere, but such trades are reversed fast in times of higher insecurity on financial markets or greater demand for liquidity, thus resulting in the rapid appreciation of the yen. When assessing such an investment, if one takes into account not only the interest rate level, but also the exchange rate risk (in the form of volatility), then carry trades financed in yen seem relatively lacking in appeal for the moment, which would indicate an appreciation of the yen over the medium term. As the exchange rate is determined by market participants though – which might look more to making profits rather than to the risks – the yen might end up staying at its low level for some time – as seen often in the past – until the next rapid appreciation sets in.

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Published on  Fri, Jul 11 2008, 09:55 GMT