Good prospects for the euro

Following the European Central Bank's first interest rate rise in five years, the obvious question to address is whether this represents the start of a series of hikes or a modest tweaking of the interest rate level.

According to HSBC Research, the latter is the more likely outcome. For the euro it was a case of two steps forward in terms of the first interest rate change, but it was one step back in terms of the dovish ECB rhetoric.

It is ironic, and perhaps not entirely coincidental, that most activity indicators have softened or at least stopped rising since the ECB hinted that a near term interest rate rise was likely.

This is true, for example, of the European Commission's business confidence survey, which is an excellent indicator of industrial production and showed its first fall in six months last November.

Meanwhile, the latest German surveys also fell, as did German and French consumer confidence, and even Eurozone M3 growth, although bank lending remained strong.

The problem for the ECB is that even internally projecting the trajectory for ECB interest rates is difficult, given the problems in reaching a decision on the ECB's governing council, and ECB president Jean-Claude Trichet's caution on the path of interest rates may have reflected that.

Caution in a world of total transparency could be interpreted as indecision and punished by the markets. Following only the data does not give any clues that the ECB would raise interest rates. It was only after certain hints from policymakers that the market started discounting the recent interest rate hike.

As far as the economy goes, it is far too early to suggest that the industrial recovery is already peaking. After all, it only began a few months ago. This highlights the vulnerability of the Eurozone economy.

In particular, there is doubt that a strong self-sustaining domestic recovery is secure yet or likely to be any time soon. This means that the market may have over-discounted the extent to which the ECB may raise rates.

It is also not unreasonable to worry about the ongoing structural obstacles to growth, the lagged effects of the high oil prices, rising interest rates and the prospect of fiscal tightening, particularly in Germany, may harm consumer spending.

According to HSBC Research, the window for interest rate rises will prove fairly short lived as the Eurozone economy begins to slow from around the middle of next year and a lower energy effect sees the headline inflation rate fall from current levels.

Expectations are for just one more 25 basis points increase over the coming year, with March the most likely month for action.

The US Federal Reserve may also be coming to the end of its tightening cycle. The rises in the US are now being matched by interest rate rises elsewhere and the power of Fed interest rate hikes have diminished as far as the US dollar is concerned.

In these circumstances, any worries about the structural imbalances will see the market look once again to the euro as a defensive currency. The US dollar rally of 2005 is very unlikely to be repeated this year.

In general, the euro's fall against the US dollar was due to three major events.

Firstly, the euro fell as the Fed raised interest rates from 2.25% to 4% with no associated move by the ECB. However, moves by the Fed are now being met by interest rate rises by the ECB, so this is unlikely to be repeated next year.

Secondly, the euro fell due to the outcome of the referendum on the EU Constitution in France and the Netherlands as the euro's aspirations as a baby brother reserve currency took a knock. This event will not be repeated in 2006.

Lastly, the euro also fell due to the flow associated with the Homeland Investment Act (HIA) repatriations by US corporates. This event will not be repeated this year. In fact, the HIA flow carries a longer term negative implication for the US dollar.

Assuming a total repatriation from US dollar and non-US dollar assets of around $400 billion, that would have accumulated a conservative 3.1% (average Fed funds rate), that would mean that next year the current account will be $12.4 billion worse off through the income balance, all other things being equal.

There was a fall in the E/$ exchange rate from 1.36 at the end of 2004 to a low of around 1.16 in 2005. The reasons for this fall have already been outlined and are not expected to be repeated.

The temptation is always to think next year will be the same as this year. Hence, at the end of 2004 the temptation was to be bearish on the US dollar and now the temptation is to be bullish on the US dollar.

HSBC Research is of the belief that in 2006 the US economy will slow, as it is only natural that when policy is tightened economies slow.

Once the market stops looking at returns and re-assesses the risks associated with these returns, the US dollar burdened with its huge external liabilities is expected to suffer and the euro will be one of the main beneficiaries.

This report was compiled by Peter Calleya, manager Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.