Euro Rallies on ECB Turning More Hawkish

Highlights

* ECB Board member Bini Smaghi warns of increasing inflationary
pressure

* FOMC confirms policy stance despite stronger growth and higher
commodity prices

* GDP collapse in UK weighs on Sterling

* S&P downgrades Japan's rating citing worsening debt situation

!! Euro Rallies On ECB Turning More Hawkish !!

The inflation rate in Germany rose to 1.9% in January - slightly less
than had been feared, but the basic problem, which is also troubling
the ECB, remains, namely that the sharp, and presumably still ongoing,
increase in the prices of imported products, particularly energy
goods, foodstuffs and industrial raw materials, could push the
inflation rate over the ECB's stability target for quite some time.

Against this backdrop, interest rates in the eurozone are continuing
to rise: the money market is now pricing in an increase in the
refinancing rate in the third quarter at the latest. During the course
of the week, 2-year Schatz yields climbed a further 8 basis points to
1.37%. The yield spread between Schatz and US Treasuries has widened
to almost 80 basis points. EUR-USD rose to over 1.37, its highest
level since November. The euro is thus more or less back to where it
was before the escalation of the debt crisis in Ireland. As long as
the inflation and interest rate hike scenario in the euro area remains
intact, however, we see little danger of a setback for the euro.

*ECB more hawkish*

A speech given by Lorenzo Bini Smaghi, a member of the ECB Executive
Board, had a strong impact on the markets this week. He gave two
reasons why the period of interest rate policy abstinence could be
coming to an end. According to Mr Bini Smaghi, the ECB assumes that
the crisis has affected productive potential, both in terms of level
and growth. The output gap is therefore contained. In this connection,
he also pointed out that in the past the output gap has frequently
been overestimated and the inflation risks underestimated. Monetary
policy has therefore remained accommodative for too long.

Furthermore, Mr Bini Smaghi stated that due to the rise in global
economic importance of emerging markets and more robust growth, prices
of commodities, energy and foodstuffs are set to go up permanently. At
the same time, the process of reducing prices of industrial goods by
having them manufactured in low-cost developing countries seems to be
coming to an end, particularly as the exchange rates of these
countries are gradually appreciating. Imported products will thus have
a stronger impact on inflation in the advanced countries. According to
Mr Bini Smaghi, if the central bank wants to maintain its inflation
objective, advanced countries must reduce domestic inflation.

*USA: FOMC rotation, policy unchanged*

The beginning of the year sees the annual rotation of voting members
of the FOMC appointed by the regional Federal Reserve Banks (with the
exception of the New York Fed). Thomas Hoenig, the president of the
Kansas Fed, who had for a long time been advocating a less
accommodative monetary policy, was also "rotated off". Thus for the
first time in over a year, the Open Market Committee reached a
unanimous decision.

Despite the four new members, the statement remained unchanged for the
most part: the FOMC confirms that private spending has picked up and
that commodity prices have risen, but still considers the rate of the
recovery insufficient to bring about a significant improvement in
labour market conditions, and sees core inflation trending downward.
Thus the Open Market Committee is sticking to its anti-deflationary
monetary policy, including its asset purchasing programme.

Although monetary policy in the US is extremely accommodative, the
fiscal situation is becoming more serious. The Congressional Budget
Office rubbed salt into the wound with its new budget estimates: due
to the extension of the Bush Administration tax cuts, the US federal
budget deficit will be about $400bn higher in the fiscal years 2010/11
and 2011/12 respectively. The budget shortfall will then rise from
8.9% last year to 9.8% (or $1,480bn) this year, and will still remain
elevated at 7% in 2011/12.

Given ever-soaring public debt levels, the rating agency Moody's fired
a warning shot. It announced that it was becoming increasingly
uncertain over the willingness and ability of the US to reduce its
debt. Thus a rating outlook downgrade to negative in the next two
years was getting more likely.

The market for municipal bonds, i.e. bonds issued by local governments
and authorities, is also problematic. Over the last few months,
significant outflows of funds have been registered; at the same time,
the municipal fiscal situation in some regions of the US (and the
fiscal situation in some states too) is deteriorating rapidly, despite
stringent austerity measures. The fiscal situation in some
municipalities and states in the US is being increasingly compared to
that in the peripheral countries in the eurozone. Policymakers have
even discussed the possibility of a bankruptcy code for states.

*GDP collapse in UK*

On Tuesday, the pound sterling came under great pressure, because the
National Statistics Office reported that the economy had suffered an
unexpected contraction in the fourth quarter: according to preliminary
figures, real GDP fell by around 0.5 percentage points compared to the
previous quarter. The Statistical Office put about 0.5 percentage
points down to the severe winter weather conditions in December. But
from the markets' point of view, even "zero growth" is quite a bitter
disappointment. Growth expectations for 2011/12 are modest as it is,
given the austerity measures planned.

The Bank of England's dilemma is becoming more acute. BoE governor
Mervyn King was forced to admit that the inflation rate could rise to
5% before slowly falling back to the target. According to the minutes,
two MPC members are now in favour of tightening monetary policy; this
news had a stabilising effect on the pound.

*Japan's rating downgraded*

Rating agency S&P has cut its rating for Japan by one notch from AA to
AA-. The reasons given for the downgrade were Japan's worsening debt
situation and the unlikelihood of it being able to tackle the debt
problem - partly due to the lack of a coherent political strategy and
partly due to weak nominal growth. This had a slight impact on the
currency market: USD-JPY and EUR-JPY firmed temporarily to 83 and 114
respectively, but the bond markets practically ignored the news. The
rating is actually of little significance to the JGB market at the
moment, as there is a strong domestic investor base and inflows of
foreign capital are continuing to increase.

Source: ActionForex.Com