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Monday May 5, 2008 - 14:08:37 GMT
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Foreign Exchange Research - USD Unable to Follow up, GBP Down Across the Board

We focus today on the unfolding divergence between the rally in US equity markets of the past 3 weeks and the macroeconomic data in the US which have swayed from neutral to deteriorating. Friday’s release of US payrolls triggered a rally in equities and the dollar partly on a decline in the unemployment rate and a smaller than expected decrease of payrolls. But markets also rallied on the Fed’s announcement to expand its TAF lending program and increase its swap lines with the European Central Bank and Swiss National Bank less than an hour before the release of the labor report.

Therefore, we reiterate our calls for cautiousness that the improved state of equity markets is a result of the Fed’s persistent liquidity operations rather than an improved economic outlook. After all, payrolls have shown losses for the past four straight months and the unemployment rate remains in the 5.0% handle. The sectoral deterioration has not abated, with construction, manufacturing and retail all continuing to shed jobs at the same pace as in Jan and Feb. The improvement largely emerged from an upswing in temporary hiring.
The implications for consumer demand merit close attention, which is why the Fed has urged to remain on data watch.

We disagree with the notion that the Fed’s removal of the negative outlook phrase from its FOMC statement was due to their knowledge of a better than expected labor report. Instead, the omission was due to relative stability in financial markets as well as the Fed’s increased preoccupation with accelerating inflation. Again, the Fed remains on data watch, but its preference to pause from cutting rates in June is due to inflation and not improved economic outlook. One should also ask what will be the elements holding equities together when earnings season is over?

Our focus on equities is related to the existing correlation between risk appetite and the Japanese yen. But the rest of the activity in currencies remains clear.
Some strengthening in the dollar has indeed materialized, but key levels have yet to be breached against the yen and the euro, which will be visited individually below. Similarly, gold has held above the key $840 foundation and is now at $868 per ounce.

Today’s 10 am EST release of the April services ISM is expected to show decline to 49.5 from 49.6 in March. Employment ISM was at 46.9 in March and in February, while new orders rose to 52.2 from 50.8.

Euro Firms Above Key Support

The euro has gained a full cent from Friday’s $1.5362 lows, as the currency succeeded in stabilizing above the major support of 1.5345-50. ECB’s Trichet today reiterated the importance to contain rising inflationary pressures amid speculation of a divergence among the Governing Council’s view on inflationary pressures and slowing growth. Only a reading above 50 and a rise in employment index in the ISM survey will likely drag the euro closer to the 1.5420s, but support will remain solid at 1.5380. Meanwhile, 1.5480 and 1.5520 will function as the near-term upside targets.

USDJPY Still Fails at 105.50

Just as the dollar failed to break above the key 1.5350 support against the euro, it is unable to breach above its 100-day MA against the yen, at 105.50. It would take convincing rise in the services ISM past the 50 figure as well as an increase in the employment component to make the 105.50 a reality today. Failure of doing so may trigger profit taking in US equities, which would be an extension of the retreat in S&P futures in Monday Asian trade. A successful breach of 105.50 would require a close above 105.55-60. We expect downside to emerge near 104.80 and 104.50.

Sterling Remains the Big Loser

Another day passes confirming our bearishness in the British Pound. Despite the dollar’s pullback against EUR and JPY, the currency is gaining substantial ground against GBP, which shed nearly half a cent to $1.9660. Lower lows and lower highs continue to dictate technical course for the pair, with support standing at 1.9645. Positive ISM to drag cable towards 1.9610. Upside to face resistance at 1.9720.

Ashraf Laidi
Chief FX Strategist
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