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FX Briefing

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Dollar hits new lows following Bear Stearns crisis

Mon, Mar 31 2008, 06:42 GMT
by BHF-Bank Economics Department

BHF-Bank

Highlights

• Hawkish ECB and higher ifo push interest rates up, EUR-USD remains firm

• Interest rate increase overdone given risks to financial system and growth

Further upward potential for the euro is limited

The financial market crisis escalated again at the beginning of the Easter week when Bear Stearns had to be rescued. Equity markets suffered heavy losses and credit spreads widened again substantially, pushing the US dollar down to new lows. USD-JPY plummeted, hitting a trough of below 96; levels last seen for a few months in 1995. EUR-USD made significant gains and rose over 1.59 for a short time.

Since then, the dollar has managed to regain some ground, particularly against the yen: during the last 9 trading days, the exchange rate has been hovering around 100. The dollar was probably boosted by the fact that equity markets, and in particular financials strengthened slightly, following the quarterly reports of Lehmann, Goldman Sachs and Morgan Stanley. The dollar’s rebound could also have been triggered to some extent by profit-taking before the long Easter weekend. One of the main reasons, however, was probably the Fed’s decision “only” to cut the Fed funds rate by the amount originally expected (still 75 basis points) to 2.25%, and to combat the liquidity problem in the money market by other means.

At first the dollar had made a significant recovery against the euro too. Shortly before the holiday weekend, EUR-USD had gone up to around 1.54 again. On the night of Easter Monday, however, the market turned round again. The euro firmed to about 1.58. And it looks as though the single currency will close the week at this level – just below the peak – too.

A spate of divergent macroeconomic data from the EMU and the US is one reason for the sustained strength of the euro. US consumer confidence plummeted again in March from 76.4 to 64.5. The Case-Shiller home price index shows sustained declines in house prices; in January, prices were almost 11% lower than a year earlier. In February, new homes sales dropped to 590,000. Sales figures have only been lower in February 1995 and during the 1990/91 recession. What is more, durable goods orders also declined markedly again by 1.7% in February, indicating, amongst other things, weak investment in machinery and equipment.

Contrary to the paltry figures from the US, European business climate data were unexpectedly positive. The German ifo business climate index improved for the third consecutive month. The manufacturing, wholesale and construction industries all recorded increases, and retail sales, which had soared in February, held up quite well. But not only the German figures were favourable; upbeat data also came from from France and Belgium. Furthermore, accelerating inflation in Germany indicates that EMU inflation could possibly rise again in March.

ECB president Jean-Claude Trichet took the same line in testimony to the European Parliament’s Committee on Economic and Monetary Affairs, emphasizing the ECB’s commitment to contain inflationary pressures. According to Mr Trichet’s comments, all that is required from the ECB at the moment is to ensure that banks get the necessary liquidity (i.e. by making central bank funds available at the refi rate). But Mr Trichet did not show any willingness to ease the constraints in the financial sector, or to ward off spillover effects into other economic sectors, by cutting interest rates.

Against a backdrop of hawkish comments from the ECB, improved economic data and higher inflation rates, interest rate cut expectations have been priced out for the euro area. Going by Eonia swaps, markets have reduced their rate cut expectations by around 35 basis points to about 40 basis points (within the next 9 months) compared to the first half of March. Deposit rates rose even more sharply, mainly because risk premiums have been pushed up further due to the financial market turmoil and the impending end of the quarter. During the course of March, Euribor rates in all maturity segments from 3 to 12 months rose by over 35 points to well over 4.70%.

In our view interest rate increases in the euro area are exaggerated. It is right that macroeconomic data and ECB comments are making interest rate cuts unlikely for the time being. However, we do not see any signs suggesting that the outlook for the euro area has fundamentally improved. On the contrary, the global economic environment and the situation in the financial markets appear much more serious today than a month ago. The signs that the US is in a recession are increasing. Moreover, the constraints in the financial system have got worse. A month ago, no-one could have envisaged an institution like Bear Stearns packing up completely.

The latest European economic indicators are remarkably robust, but things could change quickly. The production figures show a sharp increase in output, whereas new orders have been levelling off since last autumn. The ifo’s strength is based solely on assessments of the current situation. By contrast, business expectations are now predominantly negative. Rising energy prices and the appreciation of the euro are additional burdens.

In this environment, we see very little upward potential for EUR-USD from its present level. In the short term, however, the situation is uncertain: next week’s economic data will probably confirm the impression of divergent macroeconomic developments in the US and the eurozone, but are not likely to have a significant impact on the markets after last week’s substantial interest and exchange rate adjustments.

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Published on  Mon, Mar 31 2008, 06:48 GMT