Sunday, May 10, 2009

FX Briefing : Downside Risks to the Economy Prevail


  • Drop in economic activity slows - but no guarantee for recovery
  • Stress tests for US banks show no unexpected risks
  • ECB takes markets by surprise with its intention to buy covered bonds

Movements on the forex markets are still mainly determined by market participants current take on global economic risks. Stock markets are one important indicator of risk assessment, and there the sentiment has been positive over the past two weeks. The rebound in stock prices has carried the Dax, for instance, close to the 5,000 threshold. This movement was supported by better than expected economic data suggesting the beginnings of an economic stabilization in the US, the EMU and Japan. The euro got support from the ECB: Not exactly consistent with economic theory, but consistent with the crisis modus in financial markets, EUR-USD benefitted from the aggressive monetary policy decisions, especially from the plan to purchase covered bonds.

For 10 of the 19 largest US banks, the results of the "stress test" showed need for additional capital to the tune of US$75bn. Treasury Secretary Tim Geithner called the results reassuring on the whole. The outcome was more or less expected, so market reaction was muted. Another sign that the stress tests have not revealed any new risks is the ongoing decline in USD Libor rates and the narrowing spreads between the Libor and the respective overnight swap rates (OIS).

Therefore the dollar - currently regarded as a safe haven by market participants - fell back against most currencies. It was mainly the emerging market currencies which benefitted from the increase in risk appetite, such as the rand, the real, the Turkish lira as well as the forint and the zloty. The Mexican peso more than made up for its losses after the swine flu outbreak. The New Zealand dollar and the Australian dollar also gained significantly. EUR-USD appreciated moderately in comparison to above 1.34.

Market participants took the ECB's actions on Thursday as positive for the euro. Whereas the cut in the refinancing rate to 1.00% and the introduction of 12-month refinancing operations had been widely expected, Mr Trichet's announcement that the ECB would start purchasing covered bonds, which includes Pfandbriefe, did come as a surprise. The exact procedure will not be decided until June, but the programme is to have a volume of €60bn. The aim is to increase market liquidity in this segment and thus to improve financing conditions.

The fact that the ECB Council did not rule out further interest rate cuts was also taken as a good sign. Given comments by Bundesbank President Axel Weber, some observers had feared that the ECB would commit itself to the current interest rate level for a longer period, thus putting in a floor here.

The ECB's remarkably active approach emphasizes that the crisis is nowhere near under control despite the current "green shoots". Admittedly a number of economic indicators came in better than expected in the past few weeks. US survey results such as the ISM and consumer confidence have been moving up, housing sales seem to be stabilizing a little and job losses have lost some momentum. In Europe and in Japan the manufacturing data has shown some bottoming out since March. This is not only reflected in the surveys of the ifo institute and the EU Commission for instance and the Japanese Small Business Confidence Index, but also in some "hard" data. In Japan and in Germany exports increased slightly in March, industrial production in Japan rose and German production at least did not drop any further. New orders in Germany increased.

This is a very welcome development, but there is no reason whatsoever for euphoria. What we are seeing is a slowdown in the contraction, not a recovery. Without such a slowdown the already catastrophic growth outlook would become even worse. But a slower decline will not necessarily turn into a recovery. The massive reduction in the level of economic activity is a considerable risk. It makes a huge difference whether economic stabilization sets in after a GDP loss of, say, 1% or after a 6% drop (compared with Q1 2008), such as in Germany for instance. The massive underutilization of capacities increases the downside risks to growth, mainly via the impending reduction in employment and rising corporate insolvencies.

We thus consider setbacks likely. When fears increase again, the dollar will benefit, even if the ECB makes use of its remaining room for further action. All in all this speaks for an appreciation of the dollar in the coming weeks.


This report has been prepared by BHF-BANK Aktiengesellschaft on behalf of itself and its affiliated companies (together "BHFBANK Group") solely for the information of its clients.

The information and opinions in this document are based on sources believed to be reliable and acting in good faith, but no representation or warranty, express or implied, is made by any member of the BHF-BANK Group as to their accuracy, completeness or correctness. Opinions and recommendations are given in good faith but without legal responsibility and are subject to change without notice. The information does not constitute advice or personal recommendation, for which the duty of suitability would be owed, but may facilitate your own investment decision. Moreover, you should seek your own advice as to the suitability of an investment matter mentioned herein. Investors are reminded that the price of securities and the income from them can go down as well as up and that the past performance of an investment or a market is not necessarily indicative for future results.

This document is for information purposes only. Descriptions of any company or companies or their securities mentioned herein are not intended to be complete, and this document is not, and should not be construed as, an offer to sell or solicitation of any offer to buy the securities mentioned in it. BHF-BANK Group and its officers and employees may have a long or short position or engage in transactions in any of the securities mentioned in this document, or in any related securities.