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Wednesday May 24, 2006 - 11:01:23 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• USD weakens in Europe, but within recent ranges. Global markets remain volatile.
• Friday’s US core PCE price index remains a key factor for how the situation develops in the shortterm.
• German IPO shows resilience in face of adversity.
• Japanese o/n rate higher again - Bird-flu back on the radar screen - US consumer sentiment lower again.
• US durable orders and new home sales, BoC policy announcement feature today.

Market Outlook

Uncertainty is still rife through markets, with volatility being seen across a broad range of asset classes. US equities slid sharply just before the close, giving up all of yesterday’s gains and more to close lower. However, while Latam markets also closed lower, many but not all Asian equity markets have stabilised a little overnight, led by Japan. European indices have fallen sharply. Adding to the sense of uncertainty were the fears circulating about possible human-to-human bird flu in Indonesia. The WHO has said that there is no evidence of the virus mutating, but that some element of human-to-human transmission could not be ruled out. There was also speculation yesterday about a particular hedge fund closing out trades in a distressed manner across a range of items. This may have accounted for the sharp market movements at the back end of the US session. Friday’s US core PCE price index is still a potentially key factor in how global market sentiment will develop in the next couple of weeks.

After stabilising in late US and Asian sessions the USD has weakened in Europe. This has primarily been in evidence against the EUR, which was supplemented by a decent IFO survey (see below), but the immediate outlook remains unclear. As noted yesterday, for the time being momentum has turned negative on EUR-USD making upside more difficult. However, below 1.2685 is needed to open up some downside risk. The 20-day moving average also comes in at 1.2747 and EUR-USD has not closed below this indicator since April 14. 1.2885- 1.2920 is the main area on top protecting 1.2970-1.30. While risk aversion is still prevalent, fundamental news continues to proceed unfavourably for the USD. The ABC consumer sentiment index released last night weakened further to its lowest level since the first week of November. This will leave some downside risk to Friday’s final estimate of May Michigan sentiment. New home sales and durable orders are due today (see below)

The German IFO survey was surprisingly resilient, with the headline index only falling back to 105.6 from 105.9 previously. There were two reasons for this. First of all, the current conditions component rose further (to 107.3 from 106.4), highlighting the more buoyant conditions still being enjoyed in Germany. Second, was the resilience of the expectations component, which only fell back to 104.0 from 105.5. Most indicators had suggested an even weaker outcome. Fuel price strength has been largely sustained since mid-April, while the threat of higher ECB rates has also intensified and the later responses to the survey may even have reflected some anxieties relating to recent equity market weakness. The ZEW expectations index, which is reasonably well correlated with IFO expectations, was also sharply lower at the last reading.

In Japan, the minutes of the April 10-11 BoJ meeting showed one member arguing that current account deposits could be reduced if the money market remained stable, while another argued that an over-rapid adjustment may itself invite rate hike speculation. As it turns out current account deposits have been significantly reduced since that time – today standing at ¥12.5trn compared to ¥25.7trn on April 10. The overnight call rate has only been nudging higher since the last week of April but has accelerated this week. Yesterday the weighted average for the o/n call rate was 0.019%, while today it has been provisionally set at 0.035%. This may not appear to be much, but apart from the odd spike higher, both are the highest levels seen since early 2001.

However, the BoJ is unlikely to allow the o/n rate to move above 0.05% over the coming month, as this will be seen as an effective rate hike, at a time when they are still effectively committed to zero rates. In fact, they are unlikely to give much verbal encouragement to the likelihood of higher rates, as demonstrated by Fukui at the press conference last week. They are set on raising rates at some point, but they will continue to be fairly deft with the rhetoric they employ, to ensure that market speculation remains under control. If this were to become unstable, amongst other things it would invite unwelcome criticism from the government. Activity indices released last night were a touch weaker than expected, but the underlying trend remains up.

Day Ahead
US – new home sales and durable orders are today’s data features. Last month, the home sales numbers came out stronger than expected, although this was merely a response to the very weak outcome that had appeared the previous month. Other survey evidence suggests the likelihood of a continuation of the overall downtrend that now seems to be in place. Core measures of durable orders are likely to fall back a little after the generally strong showing seen last month. This would just be noise rather than anything definitive by way of a trend, but sizeable declines may affect sentiment about the US economy in the current environment of high anxiety.

Canada – the BoC looks set to raise rates by 25bp but it is not an absolute done deal given current volatility in global markets. At their last meeting they upgraded their description of the economy to “operating at, or just above, its production capacity”, compared to their previous advice of it operating “at its full production capacity” and also said that “some modest further increase in the policy interest rate may be required”. However, they noted possible challenges for exporting sectors as well as the “cumulative increase in the policy interest rate since last September”. The latter was a clear reference to the notion that past tightening had yet to take effect and that this should be a factor when considering future policy changes. Exports have also since been confirmed as weak in Q1 (-4.7% q/q). Overall, a 25bp hike still seems the most likely outcome, although this could be combined with a slightly more equivocal view on what will happen to policy in future. While a rate hike would be CAD supportive, this could be more than offset by any signal that reduces future rate hike risk.

Data/event EDT Consensus*

DE CPI states (May, prel) m/m ongoing +0.2%
US Durable orders (Apr) m/m 08.30 -0.5%
US Durables ex-transport (Apr) m/m 08.30 +0.5%
CA Leading indicator (Apr) m/m 08.30 +0.4%
CA BoC policy announcement 09.00 4.25%
US New home sales (Apr) 10.00 1150k
US Fed’s Kroszner on the use of economic data 11.45
NZ Trade balance (Apr) 18.45 -NZ$210m
JP Trade balance (Apr, sa) 19.50 ¥627bn
AU House price index (Q1) q/q 21.30 0.0%

Latest data Actual Consensus*
US ABC consumer conf (w/e May 21) -19 -17 last
JP Tertiary index (Mar) m/m -0.6% -0.2%
JP All-industry index (Mar) m/m -0.4% -0.1%
DE Import prices (Apr) y/y +6.9% +6.2%
DE Import prices ex-energy (Apr) y/y +3.8% +3.2% last
SE Unemployment rate (Apr, nsa) 5.5% 5.3%
DE IFO index (May) 105.6 105.0
DE IFO current (May) 107.3 106.2
DE IFO expectations (May) 104.0 104.0
GB Business investment (Q1) q/q +1.7% +0.5%
ZA CPI (Apr) y/y +3.3% +3.2%
ZA CPIX (Apr) y/y +3.7% +3.7%
GB CBI manu orders balance (May) -12 -11 last
* 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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