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Thursday May 11, 2006 - 10:59:49 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• USD stabilises as Asia focuses on US FX report.
• Fed statement is not that hawkish – suggests likelihood of pause in June.
• After recent moves there is a natural risk of some consolidation, but USD sentiment is likely to remain fragile.
• German GDP disappointment offset by solid Eurozone GDP.
• GBP outperforms amidst heavy cross trade.
• US retail sales feature today.

Market Outlook

The USD has stabilised overnight, initially in the Asian session and a little further in Europe. The Asian market was perhaps more focused on the conclusions of the Treasury’s semi-annual FX Report, which while critical of the China’s slow move towards FX flexibility, failed to formally name them as a currency manipulator. However, this is unlikely to be enough to let the USD off the hook – most markets had expected such an outcome in any case. The perceived pressure for Asian currency adjustment will not just disappear as a result of this report. Indeed, the US appears to be making an effort to push the issue as a global problem (hence the recent IMF role) as opposed to one that should necessitate initiatives from the US alone. Also helping was the decision by US senators to halt legislation against China until September 30 at the earliest, to give them more time to adjust.

In Europe, EUR-USD was greeted early on by German GDP being confirmed at +0.4%, which while below the initial consensus was well flagged yesterday by the ECB’s Weber. Once again it is a disappointment, but there was an offset in the form of Eurozone GDP (released later in the morning), which still managed to match expectations of +0.6% q/q. Trichet said that the overall Eurozone number confirmed their own prior analysis of growth in Q1. This helped to neutralise the German GDP news, which remains an oddity. Q106 and Q405 are the weakest consecutive quarters of German growth (zero and +0.4%) since the second half of 2004, at a time when business sentiment has been rising to its highest level for 15 years. A formal breakdown of the data was not provided by the stats office at this stage, but they indicated that consumption contributed positively to the outcome. One has to presume that there are technical reasons for the underperformance, which were also evident in the weak manufacturing data seen this week – bad weather and strike action in March. The ECB bulletin was also released this morning, repeating the fairly hawkish comments offered by Trichet at last week’s press conference – “strong vigilance” and growing upside risks to inflation.

Turning to the Fed statement, it stuck closely to the messages sent by Bernanke in his recent testimony. A fair amount of uncertainty is left about whether further rate rises will be needed, but this is unavoidable as the Fed cannot know in advance what the data will tell them over coming months. Indeed, the statement was as clear as it could be in the circumstances. Three paragraphs – one on growth, one on inflation and one on policy. The key excerpts of the policy comments are as follows:

“The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.”

This alone would appear to suggest that if the data is fairly strong over the next month or so they will raise rates further on June 29. However, this is less clear when one considers what was said in the paragraph on growth.

“Economic growth has been quite strong so far this year. The Committee sees growth as likely to moderate to a more sustainable pace, partly reflecting a gradual cooling of the
housing market and the lagged effects of increases in interest
rates and energy prices.”

Their central projection is that growth will moderate and that a key factor in this regard is the impact still to be felt by past tightenings. This suggests they could give the economy a chance to respond to previous policy tightening, which could mean looking through short-term data strength as long as it is not too strong. This is going to be the tricky bit as far as the market is concerned (working out whether the data is strong enough for a rate hike in June) and will be a source of some volatility over the next month or so. However, at this stage we would see rates being left on hold on June 29 and for the Fed to reconsider that view in August/September. If growth does not moderate as they expect or if core inflation or inflation expectations rise, then a further hike would be likely. This cannot be ruled out at this stage

Overall, the Fed statement is unlikely to generate the degree of hawkishness necessary to rescue the USD, at least for now. The perception of a peaking out in the US rate cycle is likely to remain in place, although this issue could easily be reopened in coming months.

After recent USD moves there is always the risk of some further consolidation in the short-term, although USD sentiment is likely to remain fragile and renewed weakness seems the most likely outcome at some point. Above yesterday’s high of 1.2831 on EUR-USD would be a sign that this could happen fairly promptly. Trigger levels on the downside today come in at 1.2685 (this morning’s low) and 1.2660 (Tuesday’s low).

GBP has outperformed this morning amidst talk of a large order being conducted on GBP-CHF. GBP had been strengthening well before the release of the stronger than expected manufacturing output data (which brings it more into line with CBI and PMI manufacturing surveys) but there could be a risk of snap back once the pressure from the aforementioned cross trade lapses. However, GBP should retain good overall support. As we noted after yesterday’s Inflation Report, it would have been difficult for the MPC to fully validate the recent move in rate expectations. Overall, the hawkish mood in the UK money market is likely to remain in place and this should be a supporting factor for GBP.

Day Ahead
US – retail sales are likely to be fairly strong if weekly store sales are any guide, but there is likely to be some doubt over whether this will last into May given the recent slide in weekly consumer sentiment numbers. Business inventories and sales are due for March and last month sales actually registered a rare fall (-0.6% m/m). If this were to be repeated there could be some element of concern, but on the basis of other data a rebound seems more likely.

Data/event EDT Consensus*

NZ PMI manu (Apr) 08.00 53.5
US Retail sales (Apr) m/m 08.30 +0.7%
US Retail sales ex-autos (Apr) m/m 08.30 +0.9%
US Initial claims (w/e May 6) 08.30 315k
US Continuing claims (w/e Apr 29) 08.30 2462k last
US Business inventories (Mar) m/m 10.00 +0.4%
US Business sales (Mar) m/m 10.00 -0.6% last
EU ECB’s Weber speaks 12.00
GB NIESR GDP (3mths to Apr) q/q 19.01 +0.6% last
AU Housing finance (Mar) m/m 19.30 +0.5%

Latest data Actual Consensus*
US Federal budget (Apr) $118.9bn $116.5bn
US FOMC meeting outcome 5.0% 5.0%
NZ Unemployment rate (Q1) 3.9% 3.7%
JP M2 plus CDs (Apr) y/y +1.7% +1.6%
JP Bank lending (Apr) y/y +1.2% +0.4% last
AU Employment (Apr) -3.2k +5k
AU Unemployment rate (Apr) 5.1% 5.1%
CH Consumer confidence (Apr) +7 +2 last
DE GDP (Q1, prel) q/q +0.4% +0.6%
ES GDP (Q1, prel) q/q +0.8% +0.8%
SE CPI (Apr) y/y +1.5% +1.3%
SE CPI UND1X (Apr) y/y +1.5% +1.4%
IT Ind prod (Mar) m/m -0.1% +0.2%
GB Ind prod (Mar) m/m +0.7% +0.2%
GB Manu output (Mar) m/m +0.7% +0.2%
EU GDP (Q1, advance) q/q +0.6% +0.6%
IT GDP (Q1, prel) q/q +0.6% +0.5%
* 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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