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Saturday May 1, 2004 - 20:48:54 GMT

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Fed policy clearer next week

Weekly Euro/dollar analysis 03/05/04 INVESTICA Ltd

Fed policy clearer next week EUR/USD spot rate 1.1980

The firm growth figures and expectations of a monetary tightening will offer some further dollar support. There will, however, be growing uncertainty as to whether a Fed tightening will actually boost the dollar, especially with fears over the impact on capital markets. There is also the risk that the economy will stall quickly once interest rates increase. The underlying fundamentals will remain weak and the dollar's performance this week illustrates the difficulties in making further strong progress. There will be little enthusiasm for the Euro, but sentiment should stabilise after stronger than expected data. The Euro will also gain support from central bank buying from Asian central banks. Overall, the dollar is liable to correct further in the short term and the net risks suggest that the US currency will not be able to sustain any significant advance.

Data releases

GDP 4.2% Q1 04 (4.1% Q4 03)
Consumer confidence 92.9 Apr (88.5 Mar)
Chicago PMI 66.9 Apr (57.6 Mar)
Jobless claims 338,000 week ending Apr 24 (356,000 prev)


Consumer inflation 2.0% Apr (1.7% Mar)
Germany IFO index 96.3 Apr (95.4 Mar)

The week ahead †

The US employment report will be very important after the surprisingly strong figures last month. The ISM data for the manufacturing sector will be released on Monday with the services index on Wednesday. US jobless claims will be released on Thursday as will the minutes of the previous FOMC meeting.

The Fed FOMC interest rate decision will be announced on Tuesday. The statement will shed light on whether the Fed is likely to increase rates in August or possibly June.

The Euro-zone PMI index will be released on Monday with the services sector due on Wednesday. The ECB will announce its interest rate decision on Thursday.

Market analysis

The dollar strengthened to a high of EUR1.18/US$ ahead of Thursdayís US GDP data, but the figures failed to meet market expectations and this helped to trigger a sharp US currency retreat back towards 1.20.

First-quarter GDP growth was an annualised 4.2% compared with market expectations of 5.0% and rumours of near 6.0% ahead of the release. The fourth quarter figures were, however, revised up and growth is still firm. The inflation figures may prove to be the most important element of the report with the GDP deflator rising to 2.5% in the quarter from 2.0%. The personal consumption price index, which is considered important by Fed Chairman Greenspan, increased to 2.0% from 1.2% previously and there were also inflation signs in the consumer spending reports this week. The increase in inflation will reinforce expectations of higher interest rates and it remains likely that the Fed will tighten by August. In this context, the employment data next week and the Fed FOMC statement will offer vital evidence over the timing a possible move. Elsewhere, the University of Michigan consumer confidence index dipped slightly to 94.2 in April from 95.8 in March while the Chicago PMI index strengthened to 63.9 in April from 57.6 the previous month.

The dollarís medium-term outlook will be influenced strongly by the reaction to the Fedís tightening and the capital marketís performance will be crucial. Although the dollar could strengthen, the net risks point to a weaker currency, especially with capital market vulnerability.

There was significant selling of high-yield and commodity currencies during the week. In part, this was a continuation of the trend seen over the past few weeks due to expectations of higher US rates. Additional selling pressure was, however, triggered by the warnings from Chinese officials over the need for more decisive action to cool the Chinese economy. The prospect of slower Chinese demand has raised doubts over the strength of commodity prices and helped trigger a sell off in commodity currencies. The reversal of carry trades will tend to offer near-term dollar support, but the longer-term implications of any slowdown in Chinese demand will not be favourable for the US economy.

The Euro-zone data provided some relief with the German IFO index strengthening to 96.3 in April from 95.4 the previous month. This will ease the immediate concerns over a severe downturn in the Euro-zone economy. The provisional inflation rate increased to 2.0% in April from 1.7% the previous month, while ECB President Trichet remained confident over the economic outlook. These two factors combined will lessen the potential for a near-term rate cut and there is little chance of a change in rates next week. The net implications should be marginally positive for the Euro as excessive pessimism lifts.

The current account returned to surplus for February and the capital account figures were also stronger with net inflows of direct and portfolio inflows of EUR12.2bn compared with outflows of EUR26.8bn the previous month. There have been further suggestions that Asian central banks will diversify their reserves out of dollars. There is likely to be an increase in Euro reserves held overseas and this buying will provide medium-term Euro support.


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