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Euro to continue to rise in 2003 Back  
Niall Dunne says the dominant themes of 2004 will be the continuing strengthening of the euro - to 1.30 against the dollar, the slight increase in interest rates in the Euro zone, and the key role America will play in determining global economic conditions.
If the global recovery is to continue in 2004, America’s recent economic recovery will have to prove sustainable. Here’s where our forecasts begin to differ from the consensus. America’s economic growth in late 2004 was driven by historically low interest rates, and tax rebate fuelled consumer spending. So America is guaranteed a strong start to the New Year, but what will fuel growth when interest rates and taxes inevitably rise?

The market is pinning its hopes for American recovery on improving labour market conditions, but we’re not entirely convinced that job creation will improve sufficiently to sustain consumer consumption at current levels. The problem is that most of America’s recent job losses have been structural, rather than cyclical. Cyclical job losses occur when short-term adjustments are made to employment because of lulls in demand; structural job losses occur when industry relocates workers and capital, such as job losses to low cost locations like China. Even if America’s recovery gathers momentum, corporations are unlikely to relocate jobs back to the US, which points to more moderate economic growth than the market expects. We can’t expect America’s labour market to strengthen on its own.

That’s why we are calling for a further significant depreciation of the dollar in the year ahead, against Asian and European currencies.

However, we do fear the potential consequences of political interference in the foreign exchange market. To the White House, the appeal of an employment-generating weaker dollar is clear, especially in an election year. And while the global economy can cope with a gradual depreciation of the dollar, active political canvassing for a weaker dollar could trigger its collapse, if the Chinese and Japanese withdraw their funding of America’s current account deficit.

Through an escalation in protectionism, and direct criticism of Japanese and Chinese foreign exchange policies, America risks alienating the two countries which have effectively funded its recovery through their purchases of US government bonds. If the recovery is to continue, we must hope that the US Treasury comes to realise that the global economy will not be able to cope with any sharp, sudden dollar collapse.

In the UK, despite expected strong economic growth, we believe that the pound will remain weak, in accordance with the Bank of England’s wishes. Early hikes in Britain’s interest rate may see sterling strengthen in the first quarter of the New Year, but thereafter, we see the pound falling against the euro, as the euro rallies against the dollar. A weaker pound will also help redress Britain’s balance of trade deficit

We expect rising interest rates to dominate bond and swap markets. If America recovers as we expect, the Federal Reserve will have to concede that the Fed Funds rate at 1 per cent is no longer ‘appropriate’, and we expect America’s base rate to rise to 2 per cent by year-end 2004. Looking to the UK, we are far less hawkish than the market, and expect the Monetary Policy Committee to act with caution when rising rates. Rapid rate rises in the UK, as implied by the futures market, would likely derail Britain’s recovery, since significantly higher interest rates would hit Britain’s heavily indebted consumers hard. Finally in the Eurozone, we do not expect anything more than a 0.25 per cent rise in the ECB’s refinancing rate before year-end, unless the recent Stability and Growth Pact debacle leads to reckless Governmental spending across the continent, a scenario which we don’t expect.

So the trend in international interest rates is clear - rates are set to rise in the year ahead, and swap rates will rise in tandem. However, with specific reference to the euro yield curve, we hold with the view that we have long held: the front of the euro yield curve does not appear to represent good value. Two-year swap rates currently imply that the ECB will raise the euro area’s refinancing rate to 3 per cent in the next 24 months. Consider this for a moment: with the Eurozone optimistically expected to record below-trend 1.6 per cent growth in 2004, why would the ECB raise rates by 100bps? Germany and France may be taking steps to tackle structural rigidities, particularly in their labour markets, but these reforms take time. And the euro looks set to appreciate, which might further restrict euro area growth. In fact, if the euro appreciates to 1.30 against the dollar as we expect, the ECB might yet have to cut rates, to slow the single currency’s appreciation.

To hedge or not to hedge
No exposure should ever be left totally unhedged, unless that is a decided policy, due to the market’s unpredictability. Even those corporate treasurers with euro to sell in the year ahead may wish to protect themselves against unexpected euro weakness, although if you believe our view, any structure entered should allow you to benefit from anticipated euro strength. However, given that our 2004 forecasts call for a 10 per cent appreciation in EUR/USD, and a 6 per cent gain in EUR/GBP, our view supports treasurers who will be short euro protecting against the impact of a rising euro.

For those treasurers managing short-term debt portfolios, while we don’t necessarily believe that the front end of the euro curve offers great value, we still believe that some protection against rising rates should be sought. If the global recovery gathers momentum in 2004, euro area bond yields will rise, as will the cost of euro area swaps, irrespective of Eurozone economic fundamentals. Therefore we recommend that treasurers consider capping strategies, to protect against rising rates.

However, interest rate caps are relatively expensive at the moment, so in order to cheapen the cost of protection to the treasurer, we recommend considering interest rate collars, or perhaps flexi or step-up caps. By amending the basic cap with these features, the treasurer’s cost of hedging is reduced.

Another strategy that treasurers can consider would be to enter into a discount swap that knocks out into floating for interest periods above a pre-defined barrier. This floating rate can also be capped to minimise risk.

This would be cheaper than a standard swap although it will put you back into floating if rates move higher (however, this is where you would have been if you had not hedged in the first instance).

This is only a summary of the range of products on offer, and we would urge customers to speak with us directly, so that we can construct protection to suit specific requirements.

Finally, if managing term debt, we believe that long-term euro rates offer better value than the short end of the market. We have recently seen a significant increase in our volume of business at the far end of the curve, and customers have been securing attractive rates, using a wide portfolio of products far beyond plain vanilla swaps.

So if the past tells us anything about the future, it’s to expect the unexpected. That’s why it is advisable for treasurers to protect exposures in the year ahead.

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