FX Briefing: Divergent Monetary Policies Lift Euro Over 1.50

Highlights

- EUR-USD hits new all-time high of 1.5240, USD-JPY approaches 104
- Fed representatives indicate further monetary policy easing
- Diminishing growth momentum in EMU makes interest rate cuts likely

Divergent Monetary Policies Lift Euro Over 1.50

It took the euro three months to break its previous record of 1.4968. Many people had no longer believed that this could happen. But this week, EUR-USD sailed past the 1.50 mark for the first time ever. The European single currency is currently quoted at 1.52, and the new all-time high is now 1.5240. The yen was also boosted by the dollar's weakness. Supported by favourable Japanese economic data, USD-JPY is close to 104 at the end of the week. This is the strongest the yen has been since the end of 2004/beginning of 2005.

The move above 1.50 was triggered by a slight improvement in the ifo business climate index, and a steep drop in US consumer confidence. But the real reason is more deeply rooted: it lies in market participants' impression that the European and US economies, and their monetary policies, are drifting apart.

That diverging monetary policies in two regions trigger exchange rate adjustments is nothing new. By January at the latest, the Fed had abandoned its reservations concerning inflation risks and has been pursuing a clearly expansionary policy since then. Various Fed members, including Ben Bernanke, have explained that particularly aggressive monetary policy action is advisable to guard against “financial accelerator” effects. At the same time, the latest economic indicators confirm that the slowdown in the US is now well underway:

- In the fourth quarter, GDP growth in the US slowed to an annualised 0.6% qoq, and there was actually a drop in domestic demand.
- Existing and new home sales, and declining prices, show that the housing market contraction is still ongoing.
- The January labour market report and the indicators available for February, particularly initial jobless claims, prove that the downswing has started to affect the labour market.
- Consumer confidence has now slumped to levels usually associated with the onset of a recession, and retail sales and personal spending are, at best, stagnating, if the price effects are excluded.
- Rising prices, especially for energy and food, are curbing purchasing power.
- For the last few months, industrial production has been more or less stagnant, in fact it is actually trending down: the February surveys for the manufacturing sector have deteriorated markedly.

The ECB, on the other hand, seems to be showing little inclination to follow the Fed's example. Although it is expecting growth to weaken, it is hoping that private consumption and foreign demand, especially from buoyant emerging markets, will keep the economy going. In this growth scenario, and in view of higher cost pressure due to increased commodity prices and wage agreements, the ECB is still emphasizing the inflation risks. Indeed, Bundesbank president Axel Weber has remarked on more than one occasion, that the markets' rate cut expectations are not in line with a stability-oriented monetary policy.

Diverging monetary policy expectations and the (expected) widening of the interest rate gap as a result, have been largely responsible for EURUSD breaching the 1.50 mark. However, with regard to the impending ECB governing council meeting, there is a risk of a market correction. At the beginning of February, the ECB refrained from propagating a growth rate close to potential, and deliberately so, in our opinion. Instead, it is now only talking of “ongoing growth”. At the same time, the ECB underlined the particular macroeconomic uncertainty in connection with the credit crisis.

At the meeting next Thursday, the ECB will introduce its latest staff projections. We are expecting the inflation forecast to be raised both for this year (middle of the range 2.6-2.7%) and for 2009 (to about 2.0%). However, we are also expecting the growth projections to be cut to around 1.6% for this year and 1.9-2.0% for 2009. The uncertainty of the forecast is likely to be indicated by a spread that is wider than the ± 0.4 percentage points usually projected in March. We could envisage a range of 1.0 to 2.2% for 2008.

We regard the lower half of the range as realistic; the growth risks in the euro area have increased rather than decreased over the last few weeks: firstly, higher energy and commodity costs are squeezing companies' margins and households' purchasing power. Secondly, the appreciation of the euro is hurting companies' price competitiveness. Exports from the eurozone have already been losing momentum significantly over the past few months. Moreover, exchange rate developments seem to be increasingly affecting location and thus investment decisions. Thirdly, higher credit costs, tighter lending conditions and economic uncertainty will probably dampen investment activities. This will be particularly noticeable in residential construction, but is also likely to have an impact on investment in machinery and equipment.

Economic sentiment is constantly declining in the euro area, and the ECB Council will have to take this into account. We forecast that in the next few weeks, its monetary policy stance will shift further towards interest rate cuts. This will cap the euro's rally.

BHF-BANK

Posted in: Economy,Forex