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EUR/USD in the middle of the bandwidth again

Wed, Aug 6 2008, 11:52 GMT
by Erste Bank Bond Research Team

Erste Bank der oesterreichischen Sparkassen AG

No interest rate upside potential for franc

Yen firms slightly vs. euro

US dollar

The repeated attempts of the EUR/USD to surpass the mark of 1.60 at mid-month failed. Consequently, a countermovement set in that went below 1.55. This movement was driven primarily by the weaker economic data from Euroland, with the Ifo Index being the main supportive factor. Thus, this put a damper on any still lingering interest rate speculations. Additional support for the USD came from the declining oil price.

Another important reason for the recovery of the USD was the calming of the crisis surrounding the two mortgage lenders Fannie Mae and Freddie Mac. The government safety net that was created in the case of emergency convinced the markets and the tension eased. We expect a continued sideways movement of the EUR/USD around 1.55. The economic development on both sides of the Atlantic will not give rise to much elation for the time being. There is potential for surprises from the financial market crisis, as more US banks could still be fraught by financial difficulties. Depending on the size of the bank(s) concerned, this would weigh down the US dollar. The downside risk for the euro by contrast is a stronger-than-expected economic downswing. To date, the only thing that is clear is that the economy in Euroland slowed significantly in 2Q, but concrete figures will become available only as of mid-month. If the data are very weak, this might fuel speculation of interest rate cuts, even more so considering that the sinking oil prices ease inflationary pressure. However, we believe that it would be too early to speculate about a change of the ECB assessment, because the central bank will probably need several months to assess the sustainability of the oil price decline and of the extent of the economic cooling off. Decisive for the EUR/USD in the coming week will be the fact that the negative risks will outweigh for both economies, and thus, no clear preference for either of the two currencies will evolve. Over the medium term, however, we expect the US dollar to recover.

Swiss franc

The Swiss franc weakened slightly versus the euro in the past two weeks, but stayed in a sideways channel between 1.605 and 1.635 EURCHF. For now, we expect the sideways movement to continue. Over the long term though, we perceive some firming potential for the franc, with the movement in that direction probably being slower than originally assumed. The greatest risk to this scenario is possible financial market turbulence, as in this case, massive capital flows into the Swiss franc could lead to a rapid firming of the Swiss franc.

In Switzerland, the inflation rate is traditionally around 1% lower than in Euroland and thus the high value of 3.1% y/y received relatively little attention. Moreover, SNB President Roth said that he assumed that the current increase in prices should be only short-lived and therefore there is no need to raise interest rates at present. By contrast, the financial crisis and its effects on the UBS are still being closely watched. Unlike Credit Suisse, which seems to have meanwhile stabilized, the effects of lawsuits by institutional investment advisors in the US against the largest Swiss bank cannot yet be assessed. SNB Council Member Hildebrand recently pointed out in an interview that an end of the banking crisis was not yet in sight for certain. An interest rate hike might further weaken the Swiss banks, and we therefore expect interest rates to remain unchanged until the beginning of next year.

As we expect interest rates to remain unchanged in Euroland, there will not be any additional impulses for the exchange rate, which indicates a continued sideways movement of the franc until the end of the year.

Japanese Yen

The yen moved a bit away from the lows versus the euro and weakened versus the US dollar. As stated in the last issue of Forex News, the yen left the firming trend vs. the USD and returned to the level of mid-June. In this case as well, we assume a sideways movement, because we do not expect any decisive stimulus from interest rates to come from Japan, the US or Euroland for now. The critical 2% level of the BoJ for inflation exclusive of fresh foods has nearly been reached at 1.9%, but the BoJ does not seem to perceive any urgent need to take action yet.

The interest rate spread that makes the yen loan appear more attractive than a US dollar or euro loan, contrasts with the exchange rate risk. Taking the potential profit versus the expected risk as an indicator for the exchange rate, the yen seems to be valued too low at the current level (see Macro Markets Japan for details), and therefore, it should appreciate versus the USD slightly, but not to the extent previously expected. We have adjusted our forecast to match this expectation and in conjunction with our expectations for interest rate trends, this leads us to expect a slight firming of the yen versus the USD. As we expect a sideways movement of EUR/USD for now, the yen should also advance only slightly versus the euro. For the yen as well, there is a risk of a significant firming in the event of renewed market turmoil.

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Published on  Wed, Aug 6 2008, 11:59 GMT