Rate threat to keep traders up to the mark

Germany's Bundesbank, considered to be one of the savviest central banks in the world, has a problem. The currency market is undermining its beloved deutschmark, impudence which would typically prompt a swift slap on the wrist in the form of a rate rise. With the German economy so feeble, however, and only exports keeping the earnings of many German companies out of the red, a rate rise risks smothering the nascent recovery by pushing up borrowing costs.

The Bundesbank has warned the currency market it is contemplating higher rates. It surprised central bank watchers last week by fixing its key repurchase rate for just two out of the four weeks its council members take as a summer break. That's a timely reminder to those who might be tempted to drive the mark lower that, even on the beach, Bundesbankers are watching and can punish speculators with a rate rise.

But there's that weak German economy to worry about, which makes some investors and economists think the Bundesbank is just bluffing. And if the market decides to call that bluff, it could decide to test the bank's resolve by continuing to drive its currency down against the dollar.

Brian Venables, the senior strategist at ABN Amro in Amsterdam, believes the Bundesbank is "playing with fire". He reckons: "They've sown the seeds so that if they don't raise rates in August, the mark is heading safely for two to the dollar. Once that happens, the rate rise will come."

Bundesbank chief economist Otmar Issing backed up last week's surprise move not to fix interest rates for the full four-week holiday by warning the markets the door is open for a rate rise, and that the central bank was "not on vacation".

Spoiling the holiday was the mark's 18 per cent plunge against the dollar, with 5.5 per cent of that value being lopped off the German currency in the past month as it fell to a seven-and-a-half-year low of 1.86 marks.

The Bundesbank's key securities repurchase rate, which sets the pace for commercial borrowing costs in Germany, hasn't been touched since it was cut to an all-time low of 3 per cent on 22 August after being fixed for six months at 3.3 per cent. Few expect a change in that rate soon. A sub-committee of the Bundesbank - its eight-member Frankfurt-based directorate - has control of rates between now and the next full meeting of the 17- strong council on 21 August.

"The Bundesbank will move rates when they see fit, and I wouldn't think the economic conditions currently warrant it," says Stephanie McLennan at WorldInvest Management. "They're just playing the market."

That's not to say traders aren't taking the threat of higher rates seriously. The implied yield on the September German interest-rate futures contract, which is how the market bets on where three-month rates will be by the end of the third quarter, has jumped 12 basis points in the past month to 3.3 per cent. The gap between that yield and three-month bank lending rates has widened to about 10 basis points, up from three basis points at the beginning of the month. That shows the market sees a chance of a rise in the repo rate which would push up money market rates - though only a small rise, which might not even do the trick of stemming the currency's slide.

"To really influence the mark they would have to take a big step on rates, and there's no way they can do that," says Markus Neubauer, manager of Universal-Investment-Gesellschaft.

Bundesbank council member Hans-Jurgen Koebnick admitted last week that the central bank will have to tread a fine line between upsetting the nation's economic recovery while simultaneously restoring investor confidence in the mark. While Germany's export-driven recovery is gaining strength, it has yet to make a dent in an unemployment rate of 11 per cent. The country's retailers, who depend on sales at home for their profit, are still in a five-year slump.

"I don't think they'll do anything unless the mark suddenly went to 1.9 against the dollar within a week," said Neubauer. "They would seriously damage industry, which is profiting greatly from the weaker mark."

Germany's annual inflation rate has stayed below the Bundesbank's long- range target of 2 per cent since May 1995 and is expected to remain below that limit this year.

With the mark falling so quickly, however, there's a risk that inflation may begin to rise. Moreover, the Bundesbank is likely to be keen to bolster the mark as the planned 1 January 1999 start date for the single European currency approaches. "I think they're concerned about the speed of the move," says Ms McLennan at WorldInvest. "It implies a lack of confidence in the central bank."

With investors anticipating a big group of countries being allowed to form the single European currency, including countries with weaker economies such as Italy and Spain, analysts reckon it will be hard for the Bundesbank to rejuvenate the mark.

"The mark is now a sort of proxy for the euro, so as long as those perceptions persist, then the mark is going to be under downward pressure," says Ian Amstad, senior economist at Bankers Trust.

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