Saturday, August 29, 2009

FX Briefing : Euro Benefits from Improved Economic Indicators


  • Recovery doubts weigh on pound
  • ECB Council likely to confirm expansive monetary policy stance

EUR-USD has remained within the trading range of the last few weeks, albeit mostly at the top end due to firm equity markets and upbeat economic data from the eurozone. At the end of the week, the euro is trading at around 1.4350 - slightly less than at the end of last week. The dollar has weakened somewhat against the yen too. Towards the close of the week, USD-JPY is just under 94.

The publication of the German GDP components has confirmed that economic activity picked up slightly in the second quarter. The ifo business climate has improved in August for the fifth month in a row. The EU Commission's economic sentiment indicator also shows a significant recovery in business confidence. The index rose from 76.0 to 80.6. Thus there appears to be little risk of an economic setback in the eurozone in Q3.

Data from the US were also positive for the most part. Consumer confidence rose sharply from 47.4 to 54.1, which is particularly striking, in our view. Expectations for the future are much more positive, and the assessment of the current situation, particularly in the labour market, is not seen as quite as gloomy as in July. Furthermore, new and existing home sales picked up again substantially. Durable goods orders, however, did not increase quite as much as hoped after the 4.9% increase the previous month. Volatile aircraft orders were the main reason for the sharp rise. Nevertheless, the figures indicate that investment in machinery and equipment could increase somewhat again in Q3 for the first time in six quarters.

The pound incurred larger losses. During the course of the week, EUR-GBP rose 1.7% to around 0.88. Disappointing growth in Q2 and the Bank of England's guarded assessment of the current situation evidently had an impact. Given the comparatively positive signals from the eurozone, concern is mounting in the UK that the economic recovery could turn out to be weaker there than on the Continent.

ECB Council: No change in monetary policy

Developments in the bond markets were not in line with the economic data and the strengthening euro. Despite the positive economic signals, short-term interest rates have fallen in the euro area. In the course of the past week, the yield on two-year Bunds has dropped 10 basis points to 1.27%. Largely as a result of this, the eurozone's interest rate advantage over the US has shrunk. Yields on two-year Bunds are now only 20 basis points higher than on equivalent US Treasuries. In the last few weeks, the difference had been about 30 basis points.

The fact that bond markets in the euro area have shown strength is likely to be connected to the upcoming meeting of the ECB Council. Leading central bankers have warned of too much growth optimism. The central bank did revise its growth forecast for 2009/10 slightly upwards last month, but it nevertheless expects the road to recovery to be bumpy. The ECB report on the stability of the EU banking system, published this Friday, emphasized that credit defaults are threatening to put pressure on banks and underlined the risk of negative feedback between the real economy and the financial system.

Thus the ECB made it quite clear that it is not planning to change its monetary policy in the foreseeable future - even if the new ECB staff projections turn out to be somewhat less unfavourable than in June. The market's expectation of a continuation of the current monetary policy in combination with the ample liquidity in the money market is putting pressure on interest rates, especially at the short end.

However, the flattening at the short end of the curve has gone very far. In our opinion there is a certain risk of profit taking in connection with the ECB Council meeting or the US labour market report, or the ISM survey results.


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