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FX Briefing

Oil price decline short−lived, brings no relief to dollar

Mon, Jul 14 2008, 08:36 GMT
by BHF-Bank Economics Department

BHF-Bank

Highlights

• Banks’ problems and weak stocks weigh on dollar; euro firm

• Bernanke comments on monetary policy; no interest rate signal to be expected

Bernanke before Congress

The forex markets seem to be reverting to old habits. While the dollar lost ground against the euro and the eastern European currencies, it remained firm against the yen. EUR-USD had dropped back from 1.59 to almost 1.56 after the ECB Council meeting, but is now moving in the direction of 1.58 again. USD-JPY on the other hand strengthened in the course of the week to over 107; so EUR-JPY is still just below its alltime high of 169.46.

Between July 2007 and April 2008 the typical reaction was to short USD-JPY when markets were showing increasing signs of distress, i.e. stock markets fell and credit spreads widened. This pattern of behaviour meant that credit default swap spreads and implicit volatilities for stocks and USD-JPY were closely correlated (see chart). But for two months now this connection has been severed. Stock market volatility and credit spreads have risen, but volatility in USDJPY did not follow suit. Quite the contrary:USD-JPY actually appreciated slightly during this phase, from around 104 to around 107.

So the yen’s time as a „safe haven“ appears to be over. The current pattern is more reminiscent of carry trades. Signs of distress such as falling stock prices and rising oil prices trigger shifts from the dollar into the euro which bears more interest. Zloty, Forint and the Czech koruna all reported further strong gains.

The dollar’s current weakness against the euro is largely due to the continued fall-out from the credit and housing market crises, which is mainly centred in the US. In the past few days markets have focussed on Wachovia’s disastrous quarterly earnings report and, above all, on a possible insolvency of Fannie Mae und Freddie Mac, the government-sponsored mortgage financiers, which have about US$5,000bn – almost half of all US mortgage loans – on their books, or guarantee them.

Oil prices were extremely volatile this week, dropping to $136 only to bounce back to around $144 per barrel on reports of Iranian missile testing, terrorists announcing the end of the ceasefire in Nigeria and a planned strike by oil workers in Brazil.

Market development next week is likely to be dominated by news from the USA. The most important event is Ben Bernanke’s semi-annual report to Congress. On Wednesday he will speak before the Senate Banking Committee, on Thursday before the House of Representatives Financial Services Committee. We expect his testimony to be along the lines of the FOMC statement from 25 July, with risks both on the inflation and the growth side.

Mr Bernanke will probably strongly emphasize the inflation risks that are resulting from energy and other commodity prices, with the dollar weakness amplifying the problem. However, the Fed will bank on slow growth and the decline in employment to restrict the scope for general price increases and to restrain inflation expectations. We therefore think the Fed will leave its forecast for the PCE core deflator basically unchanged. In April it had forecast 2.2 to 2.4% (Q4 2008) and 1.9 to 2.1% (Q4 2009). But the headline rate might be revised up because of the latest increase in energy and food prices.

In April the growth forecast for Q4 2008 had been 0.3 to 1.1%. This might in fact be adjusted upwards: The second and the third quarter are likely to show stronger growth than originally assumed because consumption has remained robust, aided by the tax cheques. In addition, export growth was quite strong.

But the current spate of positive news is unlikely to lift the Fed’s mood much. Rocketing prices for energy and other commodities are draining purchasing power from households, further damping demand which is already burdened by the decrease in employment and the housing market weakness. Moreover, banks are still grappling with the consequences of the housing market and credit crises, which makes access to credit more difficult and more expensive. The speculation around the state of Fannie Mae and Freddie Mac shows to what extent the financial sector in the US is currently dependent on the central bank providing liquidity and on (explicit or implicit) government guarantees.

Ben Bernanke’s message is likely to be that risks to growth and financial market stability are still too acute and inflationary risks not acute enough to tighten monetary policy. This basically dovish message initially speaks for a further dollar weakening. However, markets, and equity markets in particular, have priced in a lot of negative sentiment in the past few days. The potential for further dollar losses is thus likely to be limited.

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Published on  Mon, Jul 14 2008, 08:43 GMT

Archive

• Bank of England softens its tone despite rising inflation
  Published On Mon, Aug 18 2008, 08:14 GMT
• ECB admits that the economy is weakening
  Published On Mon, Aug 11 2008, 11:45 GMT
• In Q2 GDP in the eurozone could have fallen for the first time
  Published On Mon, Aug 4 2008, 06:38 GMT
• Weakening oil demand moves into focus, oil price drops
  Published On Mon, Jul 28 2008, 06:42 GMT
• Oil price decline short-lived, brings no relief to dollar
  Published On Mon, Jul 14 2008, 08:36 GMT

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