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Thursday March 30, 2006 - 11:35:12 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• Markets show resilience in absorbing Fed rate hike.
• EUR should benefit from this ahead of next week’s ECB meeting.
• Higher risk currencies are likely to enjoy some short-term respite.
• AUD starting to look better with gold advancing strongly – Australian data is due tonight.
• Icelandic rate hike helps ISK, but this is a perverse reaction and is likely to be reassessed.
• NZ business confidence, US jobless claims feature today – Japan CPI/labour market data this evening.

Market Outlook

The price action over the past 24 hours suggests that the market has absorbed the Fed rate hike and the implications it carried for both USD interest rate support and (via liquidity squeeze arguments) higher yielding or peripheral currencies. After strengthening initially after the Fed move the USD has fallen back against the EUR, while peripheral currencies like the NZD and AUD have stabilised after initial weakness. The BRL and the MXN have also showed little follow-through weakness after being marked down at sensitive times e.g. straight after the Fed move and at yesterday’s North American open.

On the face of it, USD interest rate support looks fairly solid and from time to time anything that aggravates this e.g. very strong US data, will create moments of USD strength. However, the market will continue to question how long this will last and what will ultimately replace it i.e. negative balance of payments fundamentals. How this plays out in the FX market will depend upon the individual circumstances of each currency. In terms of the majors, the EUR looks best positioned at the current time because rate expectations are currently in the ascendancy, while GBP is more vulnerable because few such positive fundamental arguments are currently presenting themselves. Arguments in favour of the CHF and JPY are also unconvincing given the very low rate backdrop that remains in place on these currencies, although the JPY will be sensitive to tonight’s CPI data (see below).

In this environment, EUR-USD strength (and strength in major EUR crosses) is favoured ahead of next Thursday’s ECB meeting. 1.2120 is the main barrier that needs to be overcome in this regard, which would open the way towards 1.2190- 1.2210, although this will most likely hold ahead of next Thursday. It is probably too soon for the ECB to pull the trigger again (also three days before the Italian election), although the market may become increasingly nervous about such an eventuality given the comments being advanced by ECB officials (none have made any attempt to discourage the recent hardening in rate expectations) and the strength in the economic data. There is little justification for having interest rates at such a low level and recent data will have pushed this point home further in the eyes of most ECB members.

For other higher-risk currencies, the generally nervous backdrop will remain in place, given that global rates are heading higher. However, there should be some respite for such currencies in the short-term, given the resilience shown in the wake of the Fed rate hike. The recovery in the ISK this morning, following a larger than expected 75bp Icelandic rate hike, is also helping to soothe general concerns. However, one has to wonder in what way a substantial rate rise actually contributes to an improvement in economic prospects in Iceland. A higher interest rate may offer some enhanced compensation for the risk of holding the ISK, but it also increases the risks! The market’s response to this morning’s move could quickly be reassessed.

The stabilisation in the AUD has also been helped by the strength in the gold price, which moved up significantly yesterday. The further rally in gold this morning would appear to confirm that it has broken out of the consolidation pattern in place since the previous peak in early February. The AUD seems, more than ever, to have been determined by global risk factors in recent times, rather than anything inherently negative. This is in contrast to some other recent losers like the NZD and PLN, where there have been genuinely negative fundamental developments. However, further gold price strength and a continuation of recent domestic data improvements should offer some independent support in the current environment. This morning’s break above 0.7125 is encouraging and further gains are favoured in the AUD in the short-term. How far this runs will depend upon this evening’s Australian data, today’s New Zealand business confidence and tonight’s Japanese CPI.

Day Ahead
New Zealand – business confidence is out today and this number has been generally soft over the past few months, standing just above levels last seen in 1988. Given recent developments in the economic numbers one would envisage a downside risk to this number, especially amongst retailers, although respondents exposed to the export sector may feel encouraged by the weakness in the NZD.

US – final GDP data is unlikely to have much impact, as revisions are typically fairly minor. Weekly jobless claims could carry more interest after the uneven performance since the turn of the year. The manner in which early year falls in claims were sustained through February suggested a trend improvement in the labour market, although the reversal in recent weeks has raised a question mark over this, with Jan and Feb performance possibly related to good weather. The market is still looking for clues on this one so there could be some sensitivity to the outcome.

Japan – CPI and labour market data feature tonight and CPI will be the main focal point. Last month saw the core y/y rate hitting +0.5% and the market is expecting a further advance this month. The CPI data will be key for rate expectations and the JPY, as well as sentiment amongst currencies that have been sensitive to talk about JPY repatriation. Labour market numbers are likely to remain strong given ongoing positive developments in general economic activity. The last two months has seen the job-to-applicants ratio reaching its highest level since 1992.

Australia – retail sales, private sector credit and building approvals are all due and it will be interesting to see whether the strength seen in the sales and credit data last month has been sustained. If it has it should allow the AUD to start distinguishing itself in a more positive manner against the NZD, where economic risk is genuinely rising.

Data/event EDT Consensus*

NZ Business confidence (Mar) 08.00 -62% last
US GDP (Q4, final est) saar 08.30 +1.7%
US Core PCE prices (Q4) saar 08.30 +2.1%
US Initial claims (w/e Mar 25) 08.30 305k
US Continuing claims (w/e Mar 18) 08.30 2472k last
CA Industrial PI (Feb) m/m 08.30 -0.5%
CA Raw materials PI (Feb) m/m 08.30 -1.8%
US Fed’s Poole speaks 12.00
CA BoC’s Dodge speaks 16.30
JP CPI Tokyo (Mar, core) y/y 18.30 +0.2%
JP CPI Nwide (Feb, core) y/y 18.30 +0.6%
JP Unemployment rate (Feb) 18.30 4.4%
JP Job-to-applicants ratio (Feb) 18.30 1.04
JP Employment (Feb) 18.30 +270k last
JP PCE workers (Feb) y/y 18.30 -0.3% last
AU Retail trade (Feb) m/m 19.30 +0.3%
AU Private sector credit (Feb) m/m 19.30 +1.0%
AU Building approvals (Feb) m/m 19.30 +1.3%

Latest data Actual Consensus*
JP Ind prod (Feb, prel) m/m -1.7% -0.1%
JP Small business confidence (Mar) 51.5 49.3 last
GB N’wide house prices (Mar) m/m +1.1% +0.5%
FR Consumer confidence (Mar) -26 -25
DE Employment (Feb) +5k -48k last
DE Unemployment (Mar) +30k -5k
SE Consumer confidence (Mar) 15.5 17.0
SE Manufacturing confidence (Mar) 3.0 3.0
* 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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