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Wednesday November 23, 2005 - 11:34:01 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• FOMC minutes dominate - but the revelations are not as dovish as some of the headlines suggest.
• However, they will shift market attention more directly on to the economic data and the possibility
of a language change at the next meeting.
• USD should remain solid as long as the data does not reveal any weakness.

Market Outlook

The USD has stabilised a little in Europe after the falls seen following yesterday’s FOMC minutes, which for the first time saw members indicating that at some point US rate hikes will need to be justified by incoming data, rather than being driven by a basic desire to eliminate policy accommodation. On the face of it this is not exactly a surprising development, given that the funds rate is moving very close to what many would consider to be neutral territory (current real funds rate of 2% is only marginally below its 10-yr average of 2.20%). However, the market will always be sensitive to anything that hints at a departure from the hitherto ‘automatic’ rate hike framework. Nevertheless, at this point these Fed observations are merely notes of caution and do not necessarily threaten rate hikes at the next two meetings, unless the data weakens.

The key passage in the text was as follows – “In that context (strong growth in economic activity), all members believed it important to continue removing monetary policy accommodation in order to check upside risks to inflation and keep inflation expectations contained, but noted that policy setting would need to be increasingly sensitive to incoming economic data. Some members cautioned that risks of going too far with the tightening process could also eventually emerge. Nonetheless, all members agreed to indicate at the conclusion of this meeting that a continued measured pace of policy firming remained likely.”

The policy of more tightening ahead clearly remains as their central scenario, with other language such as ‘eventually emerge’ suggesting little more than a natural degree of caution. However, this does not mean the minutes are insignificant as they will help to shift the market’s attention more directly on to the issue about when the Fed will pause its tightening cycle, an issue that is complicated further by the unfortunate timing of the handover between Greenspan and Bernanke. While unavoidable, it would have been a lot easier for all involved if it had taken place when Fed policy decisions were less contentious. Can Bernanke preside over his first meeting and leave rates unchanged after fourteen straight tightenings? If not, does this mean a further hike to 4.75% in March or the Greenspan Fed making it easier for him by pausing at 4.25% in January? These are all issues that add extra uncertainty to Fed policy in Q1.

There are two direct implications of the minutes. 1) It seems likely that the language of the FOMC statement will change at the Dec 13 meeting to one that lays less stress on policy accommodation removal and more on the desire to keep inflationary pressures at bay against a background of solid growth in activity. Indeed, yesterday’s minutes revealed that “several aspects of the statement language would have to be changed before long, particularly those related to the characterization of and outlook for policy.” 2) There will be higher market sensitivity to the economic data itself as the tone of inflation and economic activity indicators will clearly have a bearing on all of the issues alluded to in the minutes, including the manner in which the language evolves after the ‘policy accommodation removal’ mantra is jettisoned.

So what does it all mean for the USD? As noted above, the revelations in the minutes are not that startling in terms of the implications for rate hikes in Dec and Jan and the market was not really looking for much more than two more hikes in any case. In that regard, the FOMC is merely musing about issues the market has long mused about itself, so ultimately the market should absorb this information. If the data remains solid the USD should do likewise, although given this is Thanksgiving week there is a greater risk perhaps of some short-term corrective activity. Key for EUR-USD is the 1.1850-1.1900 area, although we still favour this to hold and for downside risk to remain in pace on EUR-USD through December. The only difference, which is significant, is that this scenario will now be more reliant on the avoidance of weaker US data. Support today is at 1.1780 down to 1.1740.

In the UK, MPC minutes were GBP supportive insofar as they showed no votes in favour of a rate cut. However, the minutes themselves were fairy uneventful, merely confirming that for the time being the MPC sees a lot of uncertainty about how the economy will develop. Essentially, this supports current market expectations about policy being on hold over the next 3-6 months.

Day Ahead
US – the final estimate of the University of Michigan’s measure of national consumer sentiment is due and it will be interesting to see whether the improvement seen mid-month has been sustained.

Japan – trade data is out tonight and while the monthly surpluses have been running below the levels seen last year, this has been due to fuel-related import strength rather than any weakness in exports. Exports have been strong so far this year.

Data/event EDT Consensus*

JP Market Holiday
DE CPI states (Nov, prel) m/m from today -0.3%
CA Leading indicator (Oct) m/m 08.30 +0.3%
US Initial claims (w/e Nov 19) 08.30 310k
US Continuing claims (w/e Nov 12) 08.30 2793k last
US Michigan sentiment (Nov, fin) 09.45 80.5
JP Trade balance (Oct, sa) 18.50 ¥0.6trn

Latest data Actual Consensus*
US ABC consumer conf (w/e Nov 20) -17 -18 last
GB MPC minutes (Nov 9-10 meeting) 9-0
ZA CPI (Oct) y/y +4.0% +4.2%
ZA CPIX (Oct) y/y +4.4% +4.6%
EU Manu orders (Sep) m/m +1.1% +0.9%
* 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.


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