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Wednesday December 14, 2005 - 11:37:16 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• Fed drops ‘accommodation’ reference but suggests more tightening ahead.
• USD weakens as market spies possible end to tightening cycle, although sentiment could prove fickle on this issue.
• Tankan disappointment not enough to stem USDJPY liquidations.
• UK labour market data hurts GBP.
• Norges Bank policy meeting, US and Canadian trade data feature today

Market Outlook

The USD has continued to weaken since the FOMC statement, with the market seemingly responding more to the removal of the accommodation reference than the signal about the likelihood of further tightening. The response says more about short-term USD sentiment perhaps as opposed to any major change in Fed rate hike expectations. The March Fed funds future was unmoved by the announcement, while the June Euro-$ future closed at 4.84% down from 4.87%.

The removal of the accommodation terminology confirms that the FOMC is in agreement that the funds rate is now at or close to a neutral area (the real funds rate using core PCE prices is now 2.45% compared to its 10-yr average of 2.19%). In other words, the first objective of Fed policy (removal of policy accommodation) is now complete. It is this that the market has focussed on, driving hopes that the Fed is very near to the end of its tightening cycle.

However, the Fed also signalled that it is now embarking on a 2nd stage to its policy - “the Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.” This clearly demonstrates that further tightening is likely in January and possibly beyond that as long as the data remains strong. How far policy proceeds into genuine tightening territory will depend upon the data, so it is difficult for the FOMC to pre-commit to any path for rate hikes. This possibly explains the use of the word ‘some’ when referring to future ‘measured policy firming’. Some have taken it as a dovish reference, but such caution is only natural given that the FOMC cannot know in advance what the data will be like. Our own view is that the funds rate does peak at 4.5% in January, although the risks are clearly on the upside given the possibility that current economic strength lasts longer than we currently believe. As for the USD, we were looking for it to peak out in Q1, but only after another rally going into year-end and January. This latter scenario is now under threat after the price action of the past couple of days, although it would be premature to write the USD off completely.

What does seem clear is that there is sufficient uncertainty to push people out of long USD positioning and it is no surprise in this regard that the USD weakness overnight has been most pronounced against the JPY, where positioning was at its highest. This could run further in the short-term, but on the basis of the current data information coming from the US, calling a peak in the funds rate cannot be done with much confidence. As the Fed also made clear in last night’s statement, “possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.” As a consequence, there should be more mileage to USD upside before it peaks in Q1, although we would be cautious about pursuing this for now. Above 1.2050 on EURUSD and below 118.20 on USD-JPY would trigger more USD selling today. Today’s US trade data may also carry more resonance in these circumstances if it is worse than expected.

Last night also saw the release of the Tankan survey, which was weaker than the market had expected. The main balances were still up on the previous period, which itself suggests that the recovery is firmly on track, but respondents were not expecting the rate of improvement to continue during the coming quarter. This pushed USD-JPY higher initially, but weak USD sentiment soon took over and the break of 119.63 (Monday’s low) accelerated the selling.

GBP was hurt by this morning’s labour market data, which revealed weaker than expected average earnings growth and higher unemployment. Coming after yesterday’s soft CPI data it further enhances the prospect of a rate cut in H1 2006 if the spending data remains soft. 0.6800-25 needs to break on EURGBP to keep this move going.

Day Ahead
Norway – the Norges Bank is likely to leave policy unchanged having raised rates as recently as November 2. Further rate rises are likely in the New Year but for now they look set to stick with the “small, not too frequent steps” approach to policy.

US – trade data was much wider than expected last month ($66.1bn), although a large part of this was due to various special factors. Total exports fell 2.6% m/m - the biggest drop since September 2001 - although port disruptions and the Boeing strike probably explained much of this weakness. In addition, imports (+2.4% m/m) were probably boosted by unusually high fuel imports because of the disruptions in the Gulf. At the time, the negative implications for the USD were reduced by the uncertainty on this issue. An improvement of some sort should be seen this month, although certain distortions (high fuel imports) will probably remain in place.

Canada – trade data will show the latest export performance and this will be one of the data releases over the months ahead that will exert an influence on BoC rate hike expectations. Exports have been strong in recent months.

Data/event EDT Consensus*

NO Norges Bank policy outcome 08.00 2.25%
US Trade balance (Oct) 08.30 -$63.0bn
US Import prices (Nov, nsa) y/y 08.30 +8.1% last
US Imp prices ex-petrol (Nov, nsa) y/y 08.30 +3.7% last
CA Trade balance (Oct) 08.30 C$6.9bn
CA Manu shipments (Oct) m/m 08.30 +0.3%

Latest data Actual Consensus*
US FOMC meeting outcome 4.25% 4.25%
NZ Retail trade (Oct) m/m -0.2% +0.3%
US ABC consumer conf (w/e Dec 11) -13 -14 last
AU Consumer sentiment (Dec) 104.7 107.6 last
JP Tankan – large manu (Dec) +21 +23
JP Tankan – large manu (Mar) +19 +23
JP Tankan – large non-manu (Dec) +17 +17
JP Tankan – large non-manu (Mar) +17 +18
JP Capex plans (Q4) +10.4% +10.3%
GB Claimant count (Nov) +10.5k +7.5k
GB Average earnings (Oct) 3m y/y +3.6% +4.0%
GB Earnings ex-bonuses (Oct) 3m y/y +3.9% +4.0%
ZA CPI (Nov) y/y +3.4% +3.4%
ZA CPIX (Nov) y/y +3.7% +3.8%
* 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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