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FX Briefing

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Fed begins discussion on when to start raising interest rates

Mon, Oct 12 2009, 05:39 GMT
by BHF-Bank Economics Department

BHF-Bank

Highlights

• Commodity currencies strengthen on Australian central bank interest rate hike

• ECB still cautious about recovery prospects, only sees gradual improvement

• Fed begins discussion on when to start raising interest rates

Dollar under pressure again

The US currency remains under downward pressure. EUR-USD is now over 1.47 again; USDJPY around 89. The negative impact of last week’s disappointing labour market report on the markets was only short-lived. Some commentators were actually of the opinion that the job losses were boosting equity markets and weighing on the dollar, arguing that the weak labour market is enabling the Fed to continue to maintain its expansionary monetary policy.

As before, the forex market reacted very sensitively to suggestions that the dollar’s international standing might be jeopardized. At the beginning of the week, it was rumoured that oil producers in the Middle East and importers in China and Japan were discussing the possibility of no longer factoring oil transactions in dollars.
This report intensified fears that members of the Gulf Cooperation Council, which are planning to introduce a common currency in 2010, could loosen their currencies’ peg to the dollar.

Then, early on Tuesday morning, the Reserve Bank of Australia surprised financial market players by raising interest rates from 3.00 to 3.25%. Australia is thus the first big advanced economy to increase interest rates. The RBA said its decision was based on the global economic recovery. Australia in particular is benefiting from the relatively strong growth in the Far East.
Unemployment had not risen as much as had been feared, and inflation would not fall as far as had been expected. Furthermore, the RBA pointed out that the housing market was picking up significantly, financing conditions had improved and equity markets were firm.

The Australian dollar soared on the RBA’s decision to hike interest rates so early. AUD-USD rose more than 4% to over 0.90, the highest level since August 2008. Together with the Australian dollar, the “commodity currencies” – the Canadian dollar, Brazilian real, New Zealand dollar, Norwegian krone and South African rand strengthened too. A new gold price record gave the rand additional support: during the course of the week, gold temporarily rose to $1061 per troy ounce.

Australia’s interest rate step is significant, as it “officially” heralds (or seems to be heralding) the upward movement in global interest rates. Up to now, central banks in the industrialised countries had held the common view that, given the macroeconomic risks, interest rate hikes were not an option. Market participants are now focusing their attention on which countries will tighten the reins next. The development of interest rate spreads is becoming more important again.

The ECB is not tipped to raise rates at the moment. The introductory statement to Thursday’s ECB governing meeting only shows a slight improvement to the assessment of the macroeconomic situation. Up to now, the ECB had been expecting a “very gradual” recovery. ECB president Jean-Claude Trichet continued to use this phrase on several occasions. Now, however, the official statement talks merely of a “gradual recovery”. In September, inflation was seen as “remaining subdued over the policy-relevant horizon”. Now the ECB is expecting inflation rates to be “moderately positive”. However, the ECB is still expecting the recovery to “remain rather uneven”. There was also no change in its assessment of low inflationary pressures over the medium term, based on the development of money supply and credit growth.

Mr Trichet was rather tight-lipped on the subject of exchange rates. He more or less repeated what had been said in the G7 statement, i.e. that excessive volatility and disorderly movement in exchange rates was detrimental. He added that the US authorities’ support of a strong dollar was extremely important. Mr Trichet’s comments were thus somewhat more moderate than in some press statements after the G20 summit in Pittsburgh and the Ecofin meeting in Göteborg.

Next week exchange rate movements are likely to depend to some extent on whether the upbeat mood in equity markets continues as the reporting season progresses. During the course of the week, the big US banks are publishing their third-quarter earnings, as well as IT firms. The minutes of the FOMC meeting on 23 September will also be in the spotlight. The latest comments of Fed representatives (particularly regional Fed presidents) show that in the US, discussions about the right timing for tightening monetary policy are underway. Fed Chairman Ben Bernanke said this week that the Fed would have to raise interest rates at some point, in order to keep inflation under control. It will be interesting to see whether this was discussed at length at the Open Market Committee meeting.

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Published on  Mon, Oct 12 2009, 05:59 GMT