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Friday May 19, 2006 - 11:03:05 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• General uncertainty helping USD to strengthen against majors as positioning is cut back.
• Very strong comments on inflation by Fed’s Lacker.
• BoJ sets scene for eventual rate firming, but retains dovish rhetoric.
• Canadian retail sales features today.

Market Outlook

The USD has strengthened against the majors in Europe, with the general air of uncertainty continuing to weigh on positioning. Even the CHF has been a casualty of this, with EUR-CHF moving higher. GBP and the JPY have also been big losers, with cable trading for a while below support at 1.8740-50. Back below 1.8700 would create further short-term downside risk – 1.8500-40 is plausible after the extent of recent gains. EURUSD is now looking at a test of 1.2685-1.2700 and below there would leave additional risk down to 1.2570-1.2600. Even a complete backtracking from French finance minister Breton failed to lift EUR-USD, highlighting the dominance of the position-cutting theme this morning. Two days ago Breton said they would do everything possible to prevent further EUR-USD gains, whereas today he said that EUR-USD was in an area that the economy could absorb and that a strong EUR also helped to mitigate high oil prices. (more on the USD and the JPY below).

The latest factor behind market uncertainty was the surprisingly blunt statement made to reporters yesterday by Richmond Fed president and voting FOMC member Lacker. He said he was unhappy with the last two inflation numbers (presumably core CPI), that “the inflation outlook is at the borderline of acceptable and perhaps moving beyond'' and that in circumstances like that, containing inflation was the primary focus. He went on to say that they would respond to the data flow and that this was a large one between the May 10 and June 29 meetings (almost two month’s worth). In other words, there is another month of data still to go, so the news flow may yet improve. He said that so far the news on inflation had been “adverse”. He concludes that “unfavourable inflation numbers and adverse movements in inflation expectations are going to require a higher path for real interest rates, and are going to make a pause less likely.''

Whether he was either talking off the cuff or expressing a view that had been sanctioned at the highest level is not completely clear, but having listened to a recording of his comments he clearly pauses after the crucial phrases so that they can be fully recorded by those in attendance. It seems unusual he was so forthright about inflation when the Fed’s preferred measure of core consumer price inflation, the core PCE price index, is not even released until next Friday. The timing was certainly bad for global markets. Other Fed speakers yesterday were less hawkish and more equivocal. Bernanke suggesting possible downside risk in the housing market and Poole stating that all options were open on rates for the months ahead and that current money market pricing was not misaligned. The market will be on high alert for further Fed comments in coming days to see whether any distinctive view is emerging, but next week’s core PCE price index will be key.

Evidence of firmer inflation and possible growth moderation are not typically the best of combinations when it comes to a currency’s fundamentals and one could argue against the USD on this basis. Higher interest rates because of inflation rather than growth are not positive for a currency as they can have implications for general economic risk and asset market performance. However, what happens in the US has broader implications for global markets and (as we have noted on several occasions) can help the USD via flows out of emerging markets and by reducing risk appetite amongst potential USD shorters. For now, more consolidation looks likely for the USD against the majors, although medium-term USD vulnerability remains in place. Note also that so far commodity markets have held in fairly well. If these also start correcting lower it would be an additional source of volatility, especially causing problems for emerging currencies against the USD. USD-JPY broke above short-term resistance at 111.35, which probably accounted for more positions being stopped out. Initially this morning the outlook was looking fairly reasonable for the JPY following a stronger than expected Japanese Q1 GDP (+0.5% q/q) and a fairly upbeat BoJ monthly report. The BoJ left their assessment of the current economic situation unchanged “economy recovering steadily” but slightly upgraded the outlook to “expected to expand moderately”. They said they expected the positive trend in consumer prices to continue as the output gap turned positive from around zero currently. However, in the press conference an hour later Fukui adopted a much softer tone, saying that he expected growth to slow to a more moderate pace and that they had in no way discussed any specific schedule for moving away from zero rates. He also reiterated that rates would remain low even after they moved away from zero. This pushed USD-JPY higher and shortly after Chief Cabinet Secretary Abe said that the government wanted the BoJ to keep rates at zero to support the economy. It was this that triggered the break of 111.35 and a rapid move higher. The next big resistance is an area running from 112.25 through to 112.75.

Day Ahead
Canada – retail sales is out and any sharp movements could have an impact on next week’s BoC policy outcome; not necessarily the rate decision itself, where a 25bp hike still seems the most likely outcome (but not assured in view of recent market volatility) but the outlook for policy in future months.

Data/event EDT Consensus*

CA Retail sales (Mar) m/m 08.30 +0.6%
CA Retail sales ex-autos (Mar) m/m 08.30 +0.7%
US Fed’s Geithner speaks 14.05

Latest data Actual Consensus*
JP GDP (Q1 1st est) q/q +0.5% +0.3%
DE PPI (Apr) y/y +6.1% +5.8%
FR Current account (Mar) €1.8bn €3.6bn
FR GDP (Q1, prel) q/q +0.5% +0.6%
IT Ind orders (Mar) m/m -3.4% -0.8%
GB BBA mortgage lending (Apr) +£5.0bn +£5.4bn
GB PSNCR (Apr) -£1.8bn -£0.7bn
* 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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