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Wednesday May 17, 2006 - 10:52:12 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• USD softens as global markets stabilise.
• Today’s US CPI data will be significant in determining whether this continues.
• Noyer reveals possible ECB concern about excessive EUR-USD strength.
• UK MPC minutes – one member votes for rate hike.
• Eurozone CPI on firm side of expectations.

Market Outlook

Calmer global markets are helping to bring out the USD bears again and the tone of today’s US CPI data (see below for preview) will be highly significant in determining whether this can continue in the short-term. As noted yesterday, the cyclical theme that has been developing in recent weeks i.e. a peaking in US rates has been supported by recent data releases and yesterday’s PPI and housing starts were also consistent with such arguments. If core CPI also comes out soft today it would be doubly negative for the USD, a) by supplementing the more muted US cyclical backdrop and b) by calming global markets and prompting a recovery in investor risk appetites. The latter is significant not only for short-term accounts in shorting the USD but also for determining emerging market flows out of the USD investor base. Any strength in core CPI would of course be badly received by equity markets and this would probably help the USD.

It may not be all one-way traffic on EUR-USD however, even if CPI is benign. While most comments from the ECB have been indicating that they are relaxed about recent EUR-USD strength, Noyer added some caution to this view yesterday. He clearly made the point that recent G7 calls for flexibility in exchange rates were aimed at Asian currencies against the majors, not between the majors themselves. He said that a big strengthening in the EUR against the USD would actually work against the overall attempt to rectify global imbalances. His argument was that the Eurozone’s role in correcting global imbalances was to boost domestic growth and that this would be undermined if a stronger EUR-USD hurt the Eurozone economy. If these comments become more commonplace they could help to cap EUR-USD around 1.30-1.3150 in the short term. Given the ongoing strength in credit growth the ECB are clearly keen to get interest rates higher. Indeed, in terms of tightening overall monetary conditions, higher interest rates will be preferred to a higher exchange rate. The ECB will not want the latter to delay the much-needed normalisation in interest rates, so they have a vested interest in EUR-USD not strengthening too much.

Eurozone CPI data this morning was on the firm side, with the headline rate confirmed at +2.4% and the core rate (+1.6%) the highest since May last year. The data offers mild support to arguments in favour of a faster pace of ECB tightening. The ECB are primarily concerned with headline CPI as they see this as the key factor in wage negotiations.

The UK MPC minutes revealed a truly split decision, with six members voting for unchanged rates, Nickell for a 25bp rate cut and Walton for a 25bp hike. Most thought the risk to GDP and CPI forecast to be finely balanced, but Walton saw inflation as above target without a rate hike, while Nickell still saw the
possibility of weak consumption and growth staying below potential. If the data continues to improve in the short-term this will invite speculation about more members voting for a rate hike, possibly before the next Inflation Report in August. Also note that this was Nickell’s last meeting so the rate cut vote will naturally disappear next month. However, while there is a clear risk of a rate hike, it is unlikely to mark the beginning of a series of moves. The consumer sector looks fragile and will likely react negatively to any rate hike. In the very short-term, some further outperformance of GBP against the EUR is conceivable but strong UK data will be required to prevent such a move from fizzling out as the June ECB meeting gets nearer.

Day Ahead
US – CPI data will be closely watched today. The Fed has stressed the importance of core inflation remaining under control, which would mean no repeat of the +0.3% showing on core CPI seen last month. Last month also saw a +0.3% reading on the more important core PCE price index, although this is not out until May 26. A +0.3% number once in a while is not uncommon and of no great concern, but two in a row would be troublesome, especially for global markets in the current fragile environment.

Data/event EDT Consensus*

NO Market Holiday
US Fed’s Guynn speaks 08.00
US CPI (Apr) m/m 08.30 +0.5%
US CPI core (Apr) m/m 08.30 +0.2%
CA Wholesale sales (Mar) m/m 08.30 +0.7%
CA Net portfolio balance (Mar) 08.30 -C$0.6bn last
US Fed’s Minehan speaks 09.15
AU AWOTE wages (Q1) q/q 21.30 +0.4% last
NZ 2006 Budget 22.00

Latest data Actual Consensus*
US ABC consumer conf (w/e May 14) -17 -16 last
AU Consumer sentiment (May) 104.1 110.7 last
AU Wage price index (Q1) q/q +0.9% +1.0% last
JP Ind prod (Mar, final) m/m +0.2% +0.2%
GB MPC minutes (May 3-4 meeting) Vote was 6 unch, 1 hike, 1 cut
GB Claimant count (Apr) +7.7k +7.3k
GB Average earnings (Mar) 3m y/y +4.2% +4.4%
GB Earnings ex-bonuses (Mar) 3m y/y +3.8% +3.9%
EU CPI (Apr) y/y +2.4% +2.4%
EU CPI ex-energy/fresh food (Apr) y/y +1.6% +1.5%
* 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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