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Friday September 2, 2005 - 10:51:14 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• Focus on Fed as situation deteriorates in hurricane affected US states.

• Rate cut is unlikely, but cannot be ruled out given the past record of the Greenspan Fed.

• Situation will need to deteriorate much further to warrant such a move, although gesture of leaving rates unchanged at Sept 20 meeting seems likely.

• USD likely to remain under pressure in the very short-term – oil prices will influence sentiment beyond that.

• Employment report features today.

Market Outlook

0 Estimates regarding the extent of the devastation in Louisiana and Mississippi seem to be rising by the day, aggravating fears about the possible disruption to the national economy through the impact on one part of the economy’s supply and distribution network. The fact that fuel prices are still at high levels is helping to amplify such fears. The scale of the rebuilding effort this catastrophe demands may well mean that the eventual net impact on economic activity is positive, however perverse this may sound. For this reason alone the Fed is likely to remain fairly comfortable with the medium-term outlook for the economy.

However, it is the short-term disruption that is the immediate focal point and the speculation about the Fed pausing its rate hike cycle or even cutting rates (given extra weight by the meeting yesterday between Bush and Greenspan) is perfectly valid. Much will depend upon how things pan out over the next couple of weeks, although the Greenspan Fed is not averse to reacting in emergency fashion when crisis situations emerge. The rate cuts that followed 9/11 supplemented an existing easing cycle, but those that accompanied the LTCM/Russian crisis were not in line with what the economic data was suggesting. The latter were in response to systemic risk in the banking system because of financial institution exposure to LTCM and the Russian situation. The current situation does not come under that banner, but a rate cut cannot be ruled out. Taking a quick look at the state of the housing market suggests that the FOMC will be averse to easing policy or disrupting its tightening cycle. However, in the current circumstances a gesture of leaving rates unchanged on September 20 would be perfectly explicable and now seems likely.

Much will still depend upon how the situation in the US develops over the next couple of weeks and this in turn will determine whether the market sees such a pause as temporary. The performance in oil prices and other economic data will be critical in this regard. The problem for the money market is that this shock has come against a background where so much short-term tightening was already discounted. The jolt to expectations has therefore been forceful, with the Dec Fed funds future (3.73%) having fallen 34bp (in rate terms) since Monday’s close.

What does this all mean for the USD? Much of the adjustment in rate expectations may now be over, but if the market starts to genuinely fear an emergency rate cut, there is clearly further damage to be done. This leaves the USD at risk in the very short-term and the move in EUR-USD above 1.2485-1.2500 suggests clear risk to the major resistance area at 1.2650- 1.2730. However, the focus may eventually switch to what happens in the medium-term and this could turn out to be more positive for the USD. As noted above, oil prices and the economic data will be key in determining how this develops. In this environment, there may not be much in the way of longevity when it comes to market positioning. The employment report (see below) is also due today.

Day Ahead
US – the August employment report is the only data feature today. Recent reports have suggested no more than modest growth in the labour market, although with other economic data having been strong, the avoidance of negative payroll news has been sufficient to support the USD. On this occasion the whole data background is under question and a weak number would clearly play on the market’s current fears. A strong number may be largely ignored.

Data/event EDT Consensus*

US Non-farm payrolls (Aug) 08.30 +190k
US Unemployment rate (Aug) 08.30 5.0%
US Average workweek (Aug) 08.30 33.7
US Hourly earnings (Aug) m/m 08.30 +0.2%

Latest data Actual Consensus*
JP Monetary base (Aug) y/y +1.1% +1.2%
EU PPI (Jul) y/y +4.0% +0.5%
*Consensus unless stated

2005, Mellon Financial Corporation Note: Although obtained from sources believed by us to be reliable, Mellon Financial Corporation and its affiliates cannot guarantee the accuracy or completeness of the information upon which this report is based. This report does not purport to disclose the risks or benefits of entering into particular transactions and should not be construed as advice in any specific instance. The views in this report constitute our judgement as of this date and are subject to change without notice.
Ian Gunner 44 20 7163 5996 06.40 EDT Monday May 31 2005


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