Highlights

  • Arab currencies’ dollar-peg is being challenged

  • Ifo and consumer prices might dampen hopes of an ECB interest rate cut


1.50 within reach

During the course of the week the dollar weakened significantly against some currencies. On Friday morning, USD-JPY dropped to 107.55, almost 3% below its level at the end of last week. The US currency thus fell to a two-and-a-halfyear low against the yen. Simultaneously, EURUSD rose to a peak of 1.4968 (+2.5% compared to last week) on Friday, hitting a new all-time high. Together with the euro, most other European currencies, especially the Swiss franc, strengthened against the dollar too. In contrast, the Canadian, Australian and New Zealand dollars all weakened again, AUD falling particularly sharply. Some emerging market currencies lost ground too, e.g. the Turkish lira, the real and (like last week) the rand.

The strong exchange rate movements took place in a relatively illiquid market environment: Thanksgiving on Thursday was the start of a long weekend in the US, and Friday was a public holiday in Japan. There were not really any tangible reasons for the dollar’s renewed weakness versus the euro and the yen. The general sentiment towards the dollar continues to be dominated by worries that the problems in the housing market and the financial sector will hurt US growth for some time to come. This in turn is fuelling expectations that the Fed will cut interest rates further.

The minutes of the FOMC meeting held on 31 October did little to change these expectations. They show that the rate cut to 4.5% was not unanimous; accordingly, further rate cuts are not likely to “sail through” without controversy. The Fed’s quarterly growth forecasts, included in the minutes for the first time, reveal that the central bankers are expecting relatively weak growth in Q4 (about 1.5% annualised quarter-on-quarter). However, for 2008, they see growth in a range of 1.8 to 2.5% again (Q4/08 compared with Q4/07). This would mean (and this is only speculation from a timing point of view) that growth would be below average in the first half of 2008 and within potential in the second half of the year.

However, at the moment market participants are taking no notice of the Fed’s signals that further interest rate cuts are not a foregone conclusion: equity markets are under pressure, credit spreads have widened again in the last few weeks. Money market tensions have increased again. As investors went for security, the yields on 10-year Bunds and T-notes fell below 4% again for the first time this week. From the markets’ point of view, the problems are so pressing that the central bank will in the last instance shelve its reservations.

Sentiment was probably influenced considerably by news from the Gulf region: at the OPEC summit last weekend there was some political sparring about dropping the dollar as reference currency for the oil trade. However, this discussion also had a serious economic policy aspect, as most Arab currencies are pegged to the dollar, which is becoming increasingly problematic: as most goods and services are imported, the depreciation of the dollar is reflected almost immediately in rising prices. In view of accelerating inflation and rapid economic growth driven by high oil revenues, a restrictive monetary policy is actually necessary, but the dollar-peg does not give any leeway for this. Pressure is mounting to drop the dollar-peg and revalue. On Tuesday morning, speculation was fuelled by a newspaper article claiming that in Saudi Arabia, resistance against dropping the dollar-peg was weakening. On Wednesday, the central bank of the UAE cut interest rates due to swelling capital flows (!).

Speculation on currency appreciation is not only strengthening capital flows into the region, which were already substantial beforehand, but is also increasing speculation of an impending reallocation of these countries’ foreign currency reserves out of the dollar into other currencies. This impression has strengthened because the US and, of late, Europe too are exerting more pressure on China and other Asian countries to increase exchange rate flexibility. Next week, an EU delegation led by ECB president Jean-Claude Trichet, Luxembourg’s prime minister Jean-Claude Juncker, and the EU Commissioner for Economic and Monetary Affairs, Joaquin Almunia, will be in Beijing. And in the middle of December, a US delegation headed by Treasury Secretary Henry Paulson will also hold talks there.

This week exchange rate developments were influenced mainly by “soft factors”, but next week “hard data” could come to the fore again. On the European side, inflation and business climate figures will be published. In Germany, inflation will probably have accelerated again markedly, from 2.4 to 2.8% in November. This is mainly due to the sharp increase in energy prices and the sustained rise in food prices. After five consecutive declines, the Ifo business climate index could take a breather: at least this is indicated by the first surveys from Belgium and the Netherlands, and the EMU purchasing managers index, all of which have improved. All in all, the figures could push expectations of interest rate cuts for the eurozone, which are now quite widespread, down a bit. That would support the euro, so 1.50 remains within reach.