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Wednesday May 10, 2006 - 10:58:12 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• EUR-USD remains firm – close above 1.2775 awaited to signal upside risk, which is growing.
• FOMC meeting unlikely to discourage USD bears if the thrust of Bernanke’s testimony is replicated.
• UK Inflation Report taken as dovish, but it does offer some support to higher rate expectations.
• US Treasury FX report unlikely to name China, but pressure for Asian reval will remain & they may refer to Japan (possible USD-JPY negative).

Market Outlook

EUR-USD remains close to recent highs, having shown little inclination to follow-through on yesterday’s corrective move and the next 24 hours or so will be significant. The FOMC announcement is later today and is likely to offer encouragement for a pause but not a definitive end to tightening (see below for full preview), while German/Eurozone Q1 GDP is due tomorrow morning. Recent German data releases (this week’s manufacturing orders and output) have both been weak, possibly due to seasonal and strike issues. This raises a further doubt, in addition to possible softness in the consumer sector, over tomorrow’s GDP outcome. If GDP once again disappoints it may take some of the edge off the recent (ECB prompted) hardening in rate expectations. However, more crucial will be the response of ECB officials to such developments. When questioned last week about the weakness of consumer spending in Germany in particular and the Eurozone in general, Trichet was anxious to play down the issue, suggesting that their central scenario was that the consumption would naturally pick-up as the recovery broadened (their central scenario). It will be interesting to see whether a similar stance is taken again if the data is weak.

Overall, unless there is something surprisingly hawkish from the Fed or very weak out of the Eurozone tomorrow, EUR-USD looks set to move higher. The risk of some consolidation is always there given the extent of current positioning and a close above 1.2775 remains the signal we are looking for to suggest an extension of the current upmove. 1.2930, 1.30 and 1.3150 would be the next levels to look at. Main support at 1.2480- 1.2520 – interim support at 1.2660.

The US Treasury’s FX Report is released late today and is unlikely to name China as a currency manipulator. However, USD-CNY may well fall in any case given that China often rewards a softer approach. Also, one of the reasons for the lack of US aggression, other than the desire to avoid going down the path of eventual protectionism, is that such issues are being increasingly embraced by G7 in general. The bigger surprise today would if the US uses the occasion to make references to
Japan as well as China.
This would be consistent with the way US rhetoric has been developing over the past month or so. This could add further pressure to the recent USD-JPY downmove. 110 has psychological significance, but the next major support is at 108.75-109.00.

The BoE’s Inflation Report revealed CPI and GDP forecasts over the next three years that were not too different to those seen in February. This is significant as the forecasts are made on the assumption that the official repo rate (currently 4.5%) follows the trajectory encapsulated by market expectations and those expectations are higher than they were in February. However, the expectations used in the forecast only incorporate a small part of the recent hardening in market rate expectations, as they are the average yield curve (0-3 year portion) seen over the 15-days prior to last week’s the MPC meeting decision. For example, end-of-year repo rates assumed in the new forecast stand at 4.6% for 2006, 4.8% for 2007 and 4.9% for end-2008 compared to a February assumption of 4.4%, 4.5% and 4.5% respectively. Indeed, current market expectations, as of today, are higher still – 4.96%, 5.24% and 5.31% for 3-mth money as represented by today’s short-sterling rate strip.

By forecasting CPI on target with only a modestly higher rate profile the report has seemingly failed to validate the full extent of the recent move in money market sentiment. However, this may be looking at it a little too mathematically. To be seen to be validating the move in full would have required them to forecast CPI above target and this would have been difficult given the MPC’s inflation target remit. It would have begged the question as to why they didn’t raise rates last week. In such circumstances today’s Report is about as far as the MPC was ever realistically going to go in validating the recent market move, so the hawkishness in the money market is unlikely to dissipate too much and GBP should not be too aggrieved.

Day Ahead
US – the FOMC meeting is the main highlight and below is the preview of this event that appeared in the Week Ahead
The central point of Bernanke’s recent testimony was that a pause in policy may happen fairly soon, but that this would not necessarily represent a peak in rates, the suggestion being that the data would hold the key to how this turns out. This position was also fairly consistent with the gist of the infamous CNBC report.

Over the past couple of weeks most of the data (weekly consumer sentiment and non-farm payrolls apart) have been strong. However, in his testimony Bernanke clearly stated a belief that strong growth would not last – “Based on the information in hand, it seems reasonable to expect that economic growth will moderate toward a more sustainable pace as the year progresses.” He specifically highlighted the slowing housing market in this regard, noting that while a gradual cooling in this market was the most likely outcome there were downside risks. On inflation, he noted that core inflation had remained subdued, but suggested that upside risks remained as long as the growth in aggregate demand exceeded the growth in productive capacity. In addition, he said that strong demand would leave the risk of higher cost pressures (fuel/commodity prices) being passed on to final prices. In sum, he seems to be saying that growth is still strong and as long as this is the case there is an upside risk to inflation, but that the central expectation is that growth will moderate, perhaps by more than the FOMC thinks due to the risks in the housing market.

So what does it mean for policy? In his testimony he said future policy actions would depend upon the data and that “specifically, policy will respond to arriving information that affects the Committee's assessment of the medium-term risks to its objectives of price stability and maximum sustainable employment. Focusing on the medium-term forecast horizon is necessary because of the lags with which monetary policy affects the economy.” These last two sentences are significant. He is attaching importance to past tightenings and the impact they may have in the medium-term (which fits in well with the expectation of a moderation in growth) and it follows that to a certain degree short-term data strength may be overlooked for a while. Overall, the observations are consistent with the notion that a pause in rates is almost upon us (most probably after one more rise this week), but this pause will only turn into a peak if a) growth moderation actually happens and/or b) core inflation and inflation expectations remain under control.

If a similar stance carries over into this week’s FOMC, a definitive peak in rates will not be signalled, but there should be some indication that a pause in rates could now be seen. How strongly that is confirmed will most likely hold the key to the market reaction. If the market is left fairly comfortable about the prospect of unchanged rates at the next meeting then the USD will likely weaken further in the short-term.

Data/event EDT Consensus*

CA New house prices (Mar) m/m 08.30 +0.6%
US Federal budget (Apr) 14.00 $77.5bn
US FOMC meeting outcome 14.15 5.0%
US US Treasury FX Report released at 16.00, press conf at 16.30
NZ Unemployment rate (Q1) 18.45 3.7%
JP M2 plus CDs (Apr) y/y 19.50 +1.6%
JP Bank lending (Apr) y/y 19.50 +0.4% last
AU Employment (Apr) 21.30 +5k
AU Unemployment rate (Apr) 21.30 5.1%

Latest data Actual Consensus*
US ABC consumer conf (w/e May 7) -16 -13 last
DE Trade balance (Mar) €14.3bn €13.3bn
DE Current account (Mar) €9.0bn €12.3bn
DE Exports (Mar) m/m -3.2% +4.6% last
DE WPI (Apr) y/y +3.2% +2.5% last
FR Ind prod (Mar) m/m +1.6% +1.0%
FR Manu output (Mar) m/m +1.6% +1.0%
SE Ind prod (Mar) m/m +0.2% +0.5%
SE Unemployment rate (Apr, nsa) 4.6% 4.5%
NO CPI (Apr) y/y +2.7% +2.4%
NO CPIX (Apr) y/y +0.8% +0.8%
GB Global trade balance (Mar) -£5.5bn -£6.3bn
GB Non-EU trade balance (Mar) -£2.6bn -£3.3bn
* 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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