Sunday, February 21, 2010

FX Briefing: Dollar Climbs after US Discount Rate Rise

  • Fed presses ahead with normalisation of liquidity management
  • EU makes no pledges to Greece, demands further austerity measures
  • UK budget situation deteriorates, pound under pressure
The forex market was quite volatile this week. Initially, the spotlight was on the Eurogroup and Ecofin council meetings in Brussels. After last week's “announcements”, finance ministers were expected to come up with concrete proposals to help Greece. Market participants were therefore disappointed that, instead of offering aid, ministers had demanded additional austerity measures for Greece.

However, despite the public laments about the EU's unwillingness to take action, it had little impact on exchange rates. It could perhaps have prompted the spate of profit-taking late on Tuesday afternoon, on the back of which the euro surged to almost 1.38 against the dollar. The fact that the minutes of the January FOMC meeting were due to be released the following day probably also helped to trigger a short-covering rally.

As from Wednesday, however, EUR-USD began to weaken again. This was initially sparked by US economic data. After a better-than-expected NY Empire manufacturing index on Tuesday, a significant increase in production in January of 0.9% confirmed the upward trend in industry. The rise in housing starts was also taken as a positive sign, although the figure of 591,000 hardly signals a turnaround.

But it was the Fed which provided the real momentum in the forex market. The minutes of the FOMC meeting make it clear that the US central bank is seriously paving the way for an exit from the emergency measures. Apart from the points outlined by Fed chairman Ben Bernanke a few days earlier in his statement to the House Financial Services Committee (see FX Briefing of 12 February), market participants were surprised to learn that the central bank was already considering starting to sell securities fairly soon.

On Thursday night, the Fed topped that by raising the discount rate, as had already been heralded in Mr Bernanke's statement and the minutes. With immediate effect, the discount rate (which roughly corresponds with the ECB's refinancing rate) was raised by 25 bp to 0.75%. Furthermore, the typical maximum maturity for primary credit loans is to be shortened to overnight. And last but not least, the minimum bid rate for the final TAF auction on 8 March is also being raised to 0.5%.

At first glance, the measures seem quite drastic, but their immediate impact will be limited. The banks have made relatively little use of the discount window. And the volume of funds available at the TAF auction had been reduced to $25bn anyway. The Fed emphasizes that the modifications do not signal any change in monetary policy, but rather a normalisation of money market transactions in light of the improvement in financial market conditions.

But whatever the Fed might say, this can be seen as a signal. The discount rate hike is the first interest rate increase; it heralds a turnaround in interest rate policy in the US. It is not clear why this decision was taken between two meetings.

Some observers think that it is to play down its importance. Others see it as emphasising the urgency of the matter. At least the Fed is preparing the ground in plenty of time to start draining liquidity from the market in the second quarter.

On Thursday night, on the back of the Fed decision, EUR-USD fell to below 1.35 for the first time since the middle of 2009. In our view, the discount rate rise is just the first of a series of measures which the Fed will introduce in the next few months to tighten monetary policy. From this side, the US dollar will remain well-supported for the time being.

This week, the pound sterling plummeted. Cable fell by around 4 cents to below 1.54; even the weak euro rose against the pound by 1 pence to almost 0.88. The sell-off was triggered by reports on the budget situation: In January, normally a month with abundant revenues, the public deficit totalled £4.3bn - which, unless counter measures are taken, bodes ill indeed.

Some leading forex market observers think that an appreciation of the yuan against the dollar is imminent. They are expecting it to appreciate by about 5%. We still doubt whether the Chinese government will alter the exchange rate in the present environment. China's main problem at the moment is credit-driven investment rather than exports. Furthermore, it would not fit into the present political landscape to comply with US exchange rate demands.

The Swiss National Bank does not comment on its currency market interventions. However, it looks as though it intervened again on Thursday, when EUR-CHF was threatening to slide below 1.4650.

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.

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