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Friday September 16, 2005 - 11:05:17 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• EUR-USD reverses yesterday’s losses in Asia, reflecting uncertainty over forthcoming events.
• EUR crosses up in Asia – drift off in Europe.
• German opinion polls, US BoP/TIC and Michigan sentiment feature today.
• Market will be looking at the BoP for evidence of US repatriation.

Market Outlook

EUR-USD recovered in Asia, with the rise triggered by the break above yesterday’s European/US high at 1.2240. The move reflected the fact that market positioning remains tentative and highly sensitive to adverse price action, given the uncertainties that lie ahead in the next few days – US balance of payments and TIC data today, German elections Sunday and the FOMC meeting next week. Indeed, most of the movement was on EUR-USD, reversing what happened yesterday. Ultimately the market wants to see the medium-term outlook for monetary policy coming from the FOMC, although today’s US data (see below for preview and a discussion of US profit repatriation) and especially the German election will also influence matters.

1.2330 needs to break on EUR-USD to suggest some upside testing, although just as the market has shied away from EURUSD downside, the fear of a robust Fed will also caution against aggressively pursuing upside. Indeed, a retest of 1.2240/50 is now underway and the US data and latest German opinion polls will influence things from there.

Other EUR crosses have also performed admirably in Asia, although what happens next week will depend upon the German election. EUR-GBP extended the move seen in the wake of yesterday’s retail sales data, which were soft but affected by unusually weak food sales. There is a trendline coming in at 0.6785 and this needs to be cleared impressively to allow further upmoves to 0.6825-40. EUR-JPY needs to get above 136.30 to keep things going and this is likely to be more difficult.

Yesterday’s SNB statement suggest they are in no mood to trigger speculation about a December rate hike, even though such a move is still highly plausible if the data continues along current lines. EUR-CHF, which was already looking bid ahead of yesterday’s announcement, could go further if 1.5520 were to break.

Day Ahead
US – Q2 balance of payments data is due and while the main focus will likely be on the size of the current account deficit, the FDI account will also be watched for signs of corporate repatriation under the Homeland Investment of Job Creation Act (JCA). In the Q1 balance of payments data the deficit on foreign direct investment eased back to just $3.4bn and this was probably first sign of repatriation flows expected under the JCA. However, the issue of JCA flows is a murky one and it is not clear whether much net inflow back into USDs will be generated at all, once other parts of the balance of payments are considered (see section below if more detail is required on this issue – it is a repeat from an earlier note we did)*).

The monthly TIC portfolio data is released and the market will probably trade off the headline inflow numbers, which were boosted last month by heavy inflows into corporate bonds. Michigan sentiment will provide some input on the state of consumer confidence in the wake of the hurricane. The latest weekly ABC consumer sentiment indicator fell sharply to its lowest level (-20) since June last year.

*BoP and repatriation
The US Bureau of Economic Analysis (BEA), who release the BoP data, have put out a paper on the issue which suggests that any inflow will be almost non-existent, primarily due to the double-entry bookkeeping principles embedded in the balance of payments. Income earned abroad by corporates is recorded in the income section of the current account as an inflow and it appears there whether or not the earnings are repatriated in that same period.

In other words, corporate earnings are recorded in the current account for the period in which they are actually earned, not repatriated. However, this earnings component is split up into *distributed earnings and *reinvested earnings and *reinvested earnings are simultaneously recorded as an outflow on the foreign direct investment category of the financial account, which makes sense. It follows that if prior *reinvested earnings* are now being brought home they will show up on this category,reducing the outflow on FDI in the quarter in question.

There was evidence of this in the Q1 balance of payments data, with the outflow on the *reinvested earnings component coming in a good $20-30bn below that seen over the past four quarters (the data is seasonally adjusted by the way). One could argue that the amounts involved should increase over coming quarters as corporates become more comfortable with the requirements of the law. However, this is not the end of the story, as the actual USD flow will also depend upon where the money comes from.

One would think that corporate treasurers presiding over retained earnings abroad will not want exposure to FX risk, so it is quite conceivable that a large part of it will be either held in USDs or hedged. If the money has been held in USDs by foreign subsidiaries in T-Bonds or deposits the closing of these positions will count as a USD outflow in the appropriate categories of the financial account and quite rightly this would suggest no overall USD flow. Even if the cash is held in foreign currency, the selling of this FX and purchase of USDs would require the counterparty on the other side of the trade to sell the USDs and to accumulate the FX. This is the static world of international BoP accounting. Clearly, the real world is a little different than this and the entities that accumulate the FX may pass it on to the detriment of the exchange rate. Such dynamics
are not picked up by the balance of payments. For our purposes we should count foreign currency liquidations to finance the repatriation as a USD positive, but this too would be neutralized in terms of overall USD flow if there were any hedges to unwind.

As one can see, gauging the flow impact of the JCA is a little tricky. Talk of a total repatriation of around $150-$200bn may be fairly close to the mark on the basis of what has been seen so far in the data, but in terms of actual FX flow this may be no more than $30-40bn, possibly less. This will of course be a oneoff item for 2005 and is not that significant in the context of a current account deficit that could be approaching $800bn this year.

Data/event EDT Consensus*

EU ECB’s Mersch, Caruana speak 06.30
US Current account (Q2) 08.30 -$193.0bn
US TIC intl portfolio balance (Jul) 09.00 +$71.2bn last
GB MPC’s Walton speaks 09.00
US Michigan sentiment (Sep, prelim) 09.45 85.6
US Fed’s Olson speaks on banking 10.00

Latest data Actual Consensus*
FR Current account (Jul) -€2.3bn -€750mln
CH Industrial production (Q2) q/q +7.6% -6.4%R
IT Ind prod (Jul) m/m +0.5% +0.3%
EU CPI (Aug) y/y +2.2% +2.1%
EU CPI ex-energy/fresh food (Aug) y/y +1.3% +1.3%
EU Ind prod (Jul) m/m +0.2% +0.4%
* 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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