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FX Briefing

Dollar holds its ground despite unfavourable economic reports

Mon, Dec 3 2007, 07:12 GMT
by BHF-Bank Economics Department

BHF-Bank

Highlights

• Bank of England could cut interest rates

• ECB’s stance likely to remain unchanged

Signs of a US economic slowdown

During the course of the week, the dollar regained some ground. EUR-USD slipped from over 1.48 to around 1.477, USD-JPY rose more sharply from just under 108 to 110.70. The dollar’s recovery was probably partly connected with US equity markets rebounding. Share price gains had pushed USD-JPY up regularly. Furthermore, currency markets have meanwhile priced in a very negative scenario for the US economy, so the dollar-negative news did not have much additional impact on the forex market.

In fact, exchange rates showed very little reaction to news which would have normally strengthened the euro and weakened the dollar. Neither the unexpected improvement in the Ifo business climate index nor the fact that German inflation accelerated further to 2.9% in November, had a sustained impact on the market. Likewise, neither the weak economic indicators from the US, nor the Fed’s Beige Book, nor hints dropped by Donald Kohn, Ben Bernanke’s deputy, that the Fed was set to cut interest rates again in December, put much pressure on the dollar.

In the US, there are now signs that the slowdown is spreading beyond the housing market. Up to now, it was mainly the consumer survey data that had signalled growing uncertainty. This trend continued in November; consumer confidence, which had still been 111.9 in July, plummeted to 87.3 in November. But now the Fed’s Beige Book shows that willingness to buy as such has in fact declined. According to the Fed, reports on retail sales were downbeat in general. Retailers’ expectations were on the pessimistic or cautious side. Inventories were higher than desired, and retailers were having to resort to early-season price discounting to support sales.

The drop in durable goods orders also reflects weaker demand. Vehicle orders in particular have continued their downward trend; after a 3.4% drop in September, they fell again by 1.4% in October. At the same time, the flood of aircraft orders, which had boosted Q2 and Q3 figures, is letting up. Furthermore, orders and deliveries of non-defence capital goods ex aircraft declined markedly in October, indicating a significant slowdown in capital goods investment growth. Finally, amid all the bad news from the US, the rise in initial jobless claims hits the eye: during the course of November, initial jobless claims increased to over 350,000. Thus the increase in non-farm payrolls (the latest figures are due to be released next Friday) is likely to have been extremely modest in November – possibly only about 40,000 new jobs.

In Europe, the focus will be on the Bank of England and ECB council meetings. As regards the Bank of England, we see a good chance of the central bank cutting interest rates by 25 basis points on Thursday. The Bank of England inflation report published recently opened the door to interest rate cuts. In our view, given the current situation, there would be little sense in delaying monetary policy easing until next spring. Even without monetary policy action, financing conditions are much more restrictive than in the middle of 2007, for example. However, the UK economy is much more vulnerable via the housing market to rising short-term interest rates than most continental economies: mortgage loans generally have variable interest rates and the proportion of UK households with mortgages is comparatively high.

The ECB is likely to remain in “wait and see mode”. However, its dilemma is growing more acute: the fact that annual inflation increased to 3% in November suggests that the “inflation hump” will turn out to be bigger than expected a month ago. The ECB Council’s 2008 inflation projections will probably be revised upwards substantially, from 2 to 2.3 or 2.4%. According to our own calculations, the average inflation rate in 2008 could even rise as high as 2.5%.

On the other hand, the financial market situation is still extremely tense. Occasional signs that things might be calming down invariably prove to be shortlived. Having declined to nearly 4.50, 3-month interbank rates have now risen again to 4.80%. Nervosity is growing as the end of the year draws closer and annual accounts are due. Moreover, higher energy costs and the appreciation of the euro will probably slow down growth and the creation of new jobs.

The ECB will not wish to add to the problems on the financial market, or fuel speculation on the appreciation of the euro. Therefore we are expecting the ECB Council’s statement on Thursday to take a softer tone. The central bank’s stance will probably remain much the same as in November.

Currency markets are not likely to be affected much by the ECB; however, if the BoE unexpectedly cuts interest rates, this could have an impact on EUR-USD. But next week’s US economic indicators could have a greater impact, depending on whether, and to what extent, they confirm the negative picture. We think that the labour market situation in particular could have deteriorated more than expected. Thus the dollar could remain on the weak side for the time being.

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Published on  Mon, Dec 3 2007, 07:19 GMT

Archive

• Oil price decline short-lived, brings no relief to dollar
  Published On Mon, Jul 14 2008, 08:36 GMT
• ECB sees no reason for further interest rate hikes for the time being
  Published On Mon, Jul 7 2008, 11:51 GMT
• Soaring oil prices and credit crisis weigh on equity markets and dollar
  Published On Mon, Jun 30 2008, 11:27 GMT
• FOMC could see risks as being fairly balanced
  Published On Mon, Jun 23 2008, 06:15 GMT
• US government comes to the aid of the dollar
  Published On Fri, Jun 20 2008, 10:09 GMT

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