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Wednesday January 4, 2006 - 11:44:57 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• Gulf of California earthquake causes some USD volatility in Europe.
• FOMC minutes fuel further talk about an approaching peak in the funds rate, although sentiment on this issue and what it means for the USD will likely remain volatile.
• Members note that the policy outlook is becoming less certain.
• UK consumer credit weak – mortgage approvals solid.
• Eurozone flash CPI eases back – suggesting no fresh cause for concern at ECB.

Market Outlook

The market interpreted the FOMC minutes as representing further evidence that a peak in the funds rate is not far off and current momentum could see EUR-USD extending up towards 1.2200-30 in the short-term if the overnight highs in the 1.2085- 95 area can be taken out. In Europe, the high was seen following reports of significant earthquake activity in the Gulf of California in Mexico, although there were no reports of any mainland damage. On the basis of what we have picked up from the US Geological Survey’s website, the fault under the Gulf of California is basically an extension of the San Andreas fault, but apparently a complex one, meaning that there are not necessarily implications for the fault further north. Unless there are reports of activity further up the fault it is unlikely to affect the USD any further.

The phrase in the minutes attracting most attention was “the number of additional firming steps required probably would not be large”, although this is not materially different to the message offered in the Dec 13 statement. The market reaction shows how sensitive sentiment is to anything that suggests a possible end to the cyclical arguments supporting the USD. The fact that yesterday’s ISM manufacturing survey came out weaker than expected also aided this move.

The minutes noted that members had been encouraged by the strength of growth in the inter-meeting period and that some concerns they had harboured about the outlook for activity had been removed. They were also more optimistic about core inflation. However, there was still an expectation that core inflation may rise initially in H106 before falling back again. There are risks both ways to policy in this regard and this was also reflected in the following observation about future policy formation - “the Committee would need to be mindful of the lags in the effect of policy firming on the economy. However, it would also have to take account of the effects of the sustained period of favorable financial conditions on asset prices and aggregate demand as well as the resulting possibility of further increases in resource utilization and pressures on prices.”

There was also some evidence that consensus building on future policy actions may become more difficult – “Views differed on how much further tightening might be required”. They concluded that “the policy outlook was becoming considerably less certain and that policy decisions going forward would depend to an increased extent on the implications of incoming economic data for future growth and inflation.”

The report still leaves an open question as to whether rates will be at 4.5% or 4.75% by the end of Q1. The April Fed funds future (the cleanest measure of funds by end- March) is now right on the fence at 4.625%, only down modestly from the 4.65% seen last Friday.

The market will naturally be keen to come to a cut and dried conclusion about whether the US rate backdrop is either positive or negative for the USD, but it is unlikely to be that simple. The market will remain fickle in response to ongoing data developments and uniform weakness or strength may be required in US economic releases for definitive USD direction to emerge. After yesterday’s ISM data there is some near-term downside risk for the USD, but the tone of the data releases tomorrow (ISM non-manufacturing ISM) and Friday (employment report) will play a role in determining how far this runs. Also keep an eye on USD-JPY, where key support is at 115.50-60 and 115.00.

Data this morning showed a modest increase in UK consumer credit for November (lowest since Dec 2000), but a strong showing on mortgage approvals. The market will wait for more information before taking a view on consumer performance over the crucial Christmas period. This morning, clothing retailer Next reported stronger sales in Nov/Dec compared to the weak Sept/Oct period, although this may reflect the fact that mild weather lasted until November and deferred purchases of winter clothing. Multi-product retailer reports are awaited. The strength in mortgage approvals is a continuation of the recovery seen in H2 2005 and they are not far away from the inflated levels seen during 2002-2003. If housing indicators continue to improve this could become an argument against a Q1 rate cut.

The flash estimate of Dec Eurozone CPI showed the y/y rate slipping to +2.2% i.e. back to where it was in Jul and Aug, before the blip up in Sept (+2.6%) and Oct (+2.5%). This would argue against any fresh inflation concerns at the ECB.

Day Ahead
US – factory orders are due out and there could be a modest reaction if there are any major revisions in the core durable orders components.

Data/event EDT Consensus*

JP Half-day close
US Chain store sls (w/e Dec 31) w/w 07.45 +2.8% last
CA Industrial PI (Nov) m/m 08.30 -0.5%
CA Raw materials PI (Nov) m/m 08.30 -2.0%
US Redbook sls (w/e Dec 31) m/m 08.55 0.0% last
US Factory orders (Nov) m/m 10.00 +2.4%
NZ Trade balance (Nov) 16.45 -NZ$0.7bn
JP Monetary base (Dec) y/y 18.50 +1.6%

Latest data Actual Consensus*
US ABC consumer conf (w/e Jan 2) -9 -10 last
CH CPI (Dec) y/y +1.0% +1.1%
GB Consumer credit (Nov) £0.9bn £1.3bn
GB Mortgage approvals (Nov, sa) 115k 115k
EU CPI (Dec, flash est) y/y +2.2% +2.2%
IT CPI (Dec) y/y +2.0% +2.1%
* 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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