The ECB and the impact on the Euro €

Date: November 29, 2005 15:00GMT 10EST

Expert: Piet Lammens, KBC Head of research

Topics:
- ECB’s Trichet pre-announces December rate hike
- Monetary policy still accommodative
- Is this the beginning of the ECB tightening cycle?
- Where will rates end up?
- How will this influence the shape of the curve?
- And how will the spread between German and US yields evolve?

Who is Piet Lammens?
Piet Lammens Born in Louvain, Belgium on February 28 1958. Law degree, Catholic University of Louvain, Belgium Legal advisor 1982-1989.CERA: Economist Research Department 1989-97. CERA Investment Bank Analyst dealing room 1998.KBC Head of Research dealing room 1998

Speech Material:

ECB’s Trichet pre-announces December rate hike

Monetary policy still accommodative
Is this the beginning of the ECB tightening cycle?
Where will rates end up?
How will this influence the shape of the curve?
And how will the spread between German and US yields evolve?
After a speech in Frankfurt on Friday, ECB President, Jean-Claude Trichet, gave markets a very clear signal that the ECB will raise interest rates at its next policy meeting on December 1st. The tone of his comments suggests that the ECB will raise rates by 25 basis points. In Trichet’s own words, the ECB will ‘modestly augment’ the present level of rates.

Today’s remarks are probably as close as the ECB can come to pre-announcing a rate rise.Trichet added that this move will only withdraw ‘some of the accommodation which is embedded in present monetary policy and we will maintain moderation and accommodation. The policy would remain accommodative’. This suggests December’s moveis set to be the first stage in a gradual process of raising rates. In essence, this seems to be the ECB’s effort to replicate the US Federal Reserve’sassurances that it [the Fed] would act in a ‘measured way’. Trichet’s comments on Monday before EU parliament however dented this outlook, as he said ‘It would be no good working assumption to consider that we are at the start of a series of interest rate increases’.

We would not draw too much conclusions out of these remarks. We still believe that the ECB is eager to bring rates to a more neutral level. The pace is however very data-dependent. So, upward pressure on rates looks set to persist. We expect the ECB will raise rates on a quarterly basis to end up the year at around 3-3.25%.
A change in ECB policy rates would mark a dramatic change in the interest rate climate. The European Central Bank’s key policy interest rate has remained unchanged since June 2003 (when it was cut to an historic low of 2 per cent). You have to go as far back as October 2000 for the last ECB rate increase.

The current extremely low level of rates has prevailed for nearly 2½ years and was put in place in response to exceptional weakness in the global economy in the aftermath of terrorist attacks of September 11th. As a result, it could be said that ECB policy rates have been at an “emergency” setting for nearly 2½ years.

Session Transcript:

FXstreet Moderator (Nov 29, 2005 10:02:11 AM)
Today I am delighted to welcome back our good friend and guest speaker Piet Lammens Head of Research in KBC..

Piet (Nov 29, 2005 10:03:35 AM)
Hi Everyone Im very happy to be back again at Fxstreet.com Thank you for joining me today I hope I can answer your questions..

FXstreet Moderator (Nov 29, 2005 10:04:35 AM)
Thank you very much, Piet Lets begin with pre Reg questions.

Piet (Nov 29, 2005 10:04:52 AM)
What are the major causes responsible for the fall of EUR/USD on the FX markets? (patne1978)

Piet (Nov 29, 2005 10:05:07 AM)
From the euro side the weaker economic growth, the political troubles in Germany and France and the lower rate environment were often named reasons. In essence 2005 EUR/USD movements boils down to two main reasons to explain the USD strength, namely the widening rate differential to the advantage of the USD and the fiscal measure to repatriate dollars, named the Homeland Investment Act (HIA)

Piet (Nov 29, 2005 10:06:48 AM)
Q2:Do you think the Euro will rise into 2006 or will it be the year of USD? (aaronsam) and If the ECB raises interest rates, what is the effect on the euro, especially compared to the dollar? (girish_005).

Piet (Nov 29, 2005 10:07:17 AM)
Yes we believe the ECB has started out on a rate hike cycle with hikes coming at approximately 3 month intervals. This should be euro supportive, that’s clear. But we need to combine this with a US Fed view: here the rate hike policy is nearing an end. The sooner the Fed pauses, the sooner the USD will ruin into trouble. This will happen in the first half of 2006 in our view,

Piet (Nov 29, 2005 10:07:35 AM)
so 2006 as a whole should be the year of the euro.

Piet (Nov 29, 2005 10:08:47 AM)
Q3:What is the impact of rising oil on euro zone economy and inflation? (libra_sdn)

Piet (Nov 29, 2005 10:08:59 AM)
A Higher oil bill signifies a transfer of means from the euro area to oil exporters and therefore a negative for (domestic) growth in Europe. Lucky Europe, the oil exporters are heavy buyers of European goods (with their enhanced purchasing power) and therefore the impact of higher oil price had only a moderate overall impact on European growth (not like during previous oil shocks).

Piet (Nov 29, 2005 10:09:13 AM)
Oil has a direct impact on inflation via higher energy prices, but to the extent it lowers demand for other goods it mitigates the overall effect on inflation.

Piet (Nov 29, 2005 10:09:23 AM)
Only one thing really matters, are higher energy prices reflected in higher wages? Given the loose labour market conditions, wages are not pushed (much) higher and so there are very little second round effects.

Piet (Nov 29, 2005 10:10:36 AM)
Q4:How do higher oil prices affect ECB policy?

Piet (Nov 29, 2005 10:10:49 AM)
The ECB doesn’t want to accommodate higher oil prices via a loose policy and therefore wants to raise rates moderately to keep real rates unchanged. If it doesn’t raise rates and inflation raises, real rates fall giving an extra stimulus to growth (and maybe) inflation. However, should inflation rise only temporarily and falls back later, the ECB shouldn’t raise rates in the first place.

Piet (Nov 29, 2005 10:11:03 AM)
So, the ECB reaction should depend on the expected, permanent effects of oil prices on inflation

Piet (Nov 29, 2005 10:11:59 AM)
Q5: Is ECB policy really driven by inflation fears?

Piet (Nov 29, 2005 10:12:18 AM)
To a small extent, it is, but there is more. Monetary policy is too loose, even if it cannot create inflation. Real rates at zero or even negative real rates create too much liquidity, distorts financial markets pricing and the pricing of risks

Piet (Nov 29, 2005 10:12:34 AM)
So, it might lead to long-term economic risks. It is anti-economic as it penalizes savers and favours borrowers.

Piet (Nov 29, 2005 10:12:43 AM)
The ECB wants a return to normality and estimated that the window of opportunity to raise rates is open now. Growth is slightly stronger and inflation gives them a good pretext.

Piet (Nov 29, 2005 10:13:56 AM)
Last preg question: With the expected rise in rate, which pair do you see having the more significant and/or longer term reaction, GBP/USD or EUR/USD? .

Piet (Nov 29, 2005 10:14:15 AM)
We expect more upside potential in EUR/USD, as we expect also EUR/GBP to rise somewhat. The ECB starts on a rate hike cycle and this should help the euro across the board. The Fed will pause at/near around the 5% level, the Bank of England will remain on pause as well, we believe, with a slight chance even for a rate cut,

Piet (Nov 29, 2005 10:14:26 AM)
so the rate differential between EUR and GBP will also close to the advantage of the single currency.

FXstreet Moderator (Nov 29, 2005 10:14:41 AM)
Thank you very much for that, Piet

FXstreet Moderator (Nov 29, 2005 10:14:54 AM)
Please post your questions now and Piet will attempt to answer as many as possible.

FXstreet Moderator (Nov 29, 2005 10:16:28 AM)
Lest go straight to LIVE Questions now..

32123 (Nov 29, 2005 10:20:27 AM)
Because trichet has said that this isn't the start of a rate-hike cycle and because core inflation is relatively flat in the euro-zone, don't u think that the intraday reaction will be limited this thursday?

FXstreet Moderator (Nov 29, 2005 10:25:55 AM)
On moment plz we seem to have a technical hitch

Terry (Nov 29, 2005 10:26:15 AM)
With the expected rise in rate, which pair do you see having the more significant and/or longer term reaction, GBP/USD or EUR/USD? Thank you.

Piet (Nov 29, 2005 10:26:28 AM)
The ECB has never tightened just once. It was always the start of a hiking cycle. In the 1999-2000 cycle, the ECB raised rates from 2.5% to 4.75% in 12 months. The number of hikes was 7 (twice 50 bps, 5 times 25 bps

Piet (Nov 29, 2005 10:27:44 AM)
Opps i mixed up the answers see this answer for questions above :

Piet (Nov 29, 2005 10:28:10 AM)
A1:Indeed, following the pre-announcement of the rate hike, the ECB immediately tried to calm the markets by saying that this is not the beginning of a series of rate hikes. This is also likely to be the tone of the press conference on Thursday. The ECB has now reached consensus on the first move,

Piet (Nov 29, 2005 10:28:21 AM)
but will probably need confirmation that the recovery remains on track before pulling the trigger again and this may take some time. In this respect, market reaction may remain limited on Thursday.

32123 (Nov 29, 2005 10:32:25 AM)
What is the best way to profit from the declining rate-spread between US and Eurozone interest rates?

Piet (Nov 29, 2005 10:32:38 AM)
t is a fiscal measure to encourage US companies to repatriate and invest in the US at an advantageous tax rate. For the most companies this rule expires at the end of the fiscal year being 31 December, so the inflow into USD may slow a bit and this is seen as a dollar negative.

Piet (Nov 29, 2005 10:33:45 AM)
Possible strategy: Go short European bonds, long US Treasuries or buy euro, sell dollar, but less obvious one can also expect the US equity markets to recoup some of their recent underperformance compared to the European equity markets.

greek (Nov 29, 2005 10:35:22 AM)
What do you think about the political pressure under which Triche &co are operating? And with an annual growth of 1.6% and finance minister of EU very virulent regarding the hikes, do you you think that ECB will be perceived as hawkish by the markets participant? I think the risk is they will dissapoint the market.

Piet (Nov 29, 2005 10:35:43 AM)
There is always political pressure, but it is counter productive. Indeed, Trichet might come out not so hawkish on Thursday, but this should give us good opportunities to enter the bond market from the short side.

Piet (Nov 29, 2005 10:35:52 AM)
It might be slightly euro negative, but time is running out for the dollar. So it might be good occasion to buy euros on dips for the longer term

Guest (Nov 29, 2005 10:38:49 AM)
Even in hypothesis that the ECB wants to raise rates to a more neutral level, will it be able to overcome the differences in economic performance between different member countries? For example, Italy clearly objects rates being raised materially.

Piet (Nov 29, 2005 10:45:24 AM)
Q5: Even in hypothesis that the ECB wants to raise rates to a more neutral level, will it be able to overcome the differences in economic performance between different member countries? For example, Italy clearly objects rates being raised materially.

Piet (Nov 29, 2005 10:45:34 AM)
Because, it correctly sees that a monetary policy with negative real rates is dangerous and without an emergency situation, rates, this means the price of money may not be absurdly low. Central bankers should enlarge their target of good inflation to a more general inflation target that includes other, namely, asset prices.

pope (Nov 29, 2005 10:47:06 AM)
what range do you see euro/usd trading for 2006

Piet (Nov 29, 2005 10:47:30 AM)
A very good question and a very tough one; it depends on so many variables and unknown factors. Let’s say though that the basic premises of ours hold true: ECB hikes with intervals and Fed halts in H1 2006 with a pause. This should mean EUR/USD shouldn’t fall below 1.10 and could even move back up towards the 1.30 zone

Piet (Nov 29, 2005 10:49:02 AM)
There always have been growth and inflation differentials across the euro zone. In this context, it has been remarkable that the pressure for higher rates during the past few weeks was mainly coming from Germany with ECB’s Issing and Weber leading the hawks, despite the relatively low level of inflation an growth in Germany compared to the rest of the euro zone

JSB (Nov 29, 2005 10:53:50 AM)
European Banks never seem to anticipate ECB moves but rather wait until immediately afterf the announcement to maker their moves. Will that happen this Thursday?

Piet (Nov 29, 2005 10:54:13 AM)
I don’t understand your question quite well. In the money market, a rate rise is completely discounted. In the forex market, it is true that the euro hasn’t yet profited from the pre-announced rate hike. So when they move Thursday, little will happen, unless the press conference brings new elements.

FXstreet Moderator (Nov 29, 2005 10:59:08 AM)
Thank you very much for that, Piet Thats all we have time for Today

Piet (Nov 29, 2005 11:00:28 AM)
Thank you very much for logging on and participating to this session. it was a very nice experience and we hope it was enlightening for all. Thank you for your questions.

FXstreet Moderator (Nov 29, 2005 11:01:07 AM)
Thank you Piet for hosting the session and you for attending and particpating also

FXstreet Moderator (Nov 29, 2005 11:01:31 AM)
Please if you questions were not answere drop Piet an email at this address :

FXstreet Moderator (Nov 29, 2005 11:01:53 AM)
peter.fontaine@kbc.be

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See you all tomorrow at 10ESt 15 GMT for another session.

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