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Thursday June 29, 2006 - 10:54:40 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• FOMC meeting should neither worsen nor alleviate current market uncertainties.
• This may see some kind of short-term relief rally for higher risk assets, but not a sustainable recovery.
• EUR-USD still carries some downside risk ahead of today’s announcement, although a recovery may be seen at some point going into next week (focus switching to ECB) as long as the events of the next two days are not too dramatic.
• Japanese CPI tonight.

Market Outlook

The USD continues to show some strength ahead of the FOMC announcement and this could extend a little further today. EURUSD has been dipping lower and is facing up to support at 1.2480-1.2510. For a full preview of the FOMC please see below, but the key point to make in terms of market implications is as follows. While it may fail to add any further to current market uncertainties about the outlook for inflation, interest rates and the risk of a hard landing, it is also unlikely to fully resolve such concerns. This may equate to a relief rally of sorts for higher risk asset markets, but it is questionable whether this will translate into a sustainable recovery.

There will also be some uncertainty about tomorrow’s core PCE price index and the risk of higher ECB rates next week, at least from an equity market perspective. It is this last factor that holds out some hope for a higher EUR-USD going into next week and this should be seen if the next two days (FOMC and core PCE price index) pass without major incident. However, 1.2680- 1.2725 will be difficult to win back.

Data this morning has not been too controversial. Money data in the Eurozone was strong but not that much stronger than expected, while mortgage lending and approvals data in the UK were ahead of expectations. The latter led to a modest hardening in UK rate expectations, but was of little help to GBP.

Norway – the Norges Bank is set to leave rates unchanged, although more important will be any indications of a faster pace of tightening in future. A more hawkish presentation is a risk in the current environment where both Swedish and Norwegian central banks are moving away from focusing on current core CPI. Support on EUR-NOK at 7.85-7.86.

US – the FOMC meeting is the main feature today and while a 25bp hike has now been priced in, key for the market reaction will be what the FOMC signals about the future. Since the last FOMC meeting there appears to have been a change of heart amongst members, which has served to wrong-foot market expectations. There had been a sense (nurtured by comments from Bernanke and the May 10 statement) that the FOMC would be prepared to look beyond any short-term rise in inflation and to the growth moderation that is part of their central forecast scenario. However, when faced with the hard facts of higher core inflation numbers the Fed appears to have taken a conscious decision to ramp up the anti-inflation rhetoric, which has been the main source of alarm for markets over the past month. Key now is whether they follow through on these warnings, as the main measures of core inflation are likely to remain elevated in the months ahead.

Signalling what they will do in the future will be a very delicate business. While they will be keen to establish/maintain their inflation fighting credentials, they will also be mindful of not coming down too hard on market sentiment, which is already fragile. The last thing they want to do is to create a dramatic deterioration in business sentiment that could create the dynamics for a hard landing.

It is worth looking at last month’s statement for clues as to what may materialise on this occasion. The three paragraphs from May 10 were split up neatly by subject matter – the first on economic activity, the second on inflation and the third on policy.

“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”.

There have been some signs of moderation already so the first sentence may be downgraded a little, while the rest of the points made are likely to be repeated as they are still applicable. Something along these lines would, in isolation, be seen as dovish as it would help to convey the point that the Fed’s medium-term focus is still on a slowdown in activity.

“As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained. Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.”

This is where the change has occurred. They will be obliged to acknowledge that core inflation is now showing signs of acceleration. Key will be whether or not the rest of the paragraph is also altered. If in Paragraph 1 they do note signs of growth moderation, will this lead them to tone down the final sentence of Paragraph 2? This is significant as it will show how much weight they are attaching to growth moderation as a constraint on future rises in core inflation. Also key will be whether they add any remarks about the importance of responding to near-term rises in inflation. This is complicated as core inflation in the present is of course a lagging indicator of past activity, but also a possible driver of inflation expectations and future inflation.

“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. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.

This final paragraph may not change at all. It seems unlikely that the Fed will be comfortable in calling time on rate rises just yet and will prefer to leave it as an open question, as was the case at the last meeting.

Overall, the Fed is unlikely to be alarmist in its attitude but may also fail to satisfactorily answer the key question about how strongly they will look at moderation in the future as opposed to inflation strength in the present. This is likely to be left as an open question, which is what an unchanged final paragraph on policy would represent. While this would not necessarily add further to the recent hardening in interest rate expectations it will also fail to offer any major reassurances to global markets.

Japan – tonight sees the latest labour market numbers as well as the all-important CPI data. The market is looking for an uptick in the core CPI y/y rate and this may add to rate hike speculation a little.

Day Ahead
Data/event EDT Consensus*

NO Norges Bank policy outcome 08.00 2.75%
US GDP (Q1, final est) saar 08.30 +5.6%
US Core PCE prices (Q1, final) saar 08.30 +2.0% (prel)
US Initial claims (w/e Jun 24) 08.30 310k
US Continuing claims (w/e Jun 17) 08.30 2439k last
CA GDP (Apr) m/m 08.30 +0.2%
CA Industrial PI (May) m/m 08.30 +0.2%
CA Raw materials PI (May) m/m 08.30 +1.0%
NZ Business confidence (Jun) 09.00 -31.3% last
EU ECB’s Trichet speaks 09.45
US FOMC meeting outcome 14.15 5.25%
FR Unemployment rate (May) 18.00 9.3%
FR ILO job seekers (May) m/m 18.00 -20k
JP CPI Tokyo (Jun, core) y/y 19.30 +0.4%
JP CPI Nwide (May, core) y/y 19.30 +0.6%
JP Unemployment rate (May) 19.30 4.1%
JP Job-to-applicants ratio (May) 19.30 1.04
JP Employment (May) 19.30 -50k last
JP Overall PCE (May) y/y 19.30 -2.2%
AU Private sector credit (May) m/m 21.30 +1.1%

Latest data Actual Consensus*
JP Ind prod (May, prel) m/m -1.0% -0.2%
JP Small business confidence (Jun) 50.1 49.2 last
CH CPI (Jun) y/y +1.6% +1.6%
GB N’wide house prices (Jun) m/m +0.3% +0.4%
DE Unemployment (Jun) -49k -30k
DE Employment (May) +36k +10k last
EU M3 (May) y/y +8.9% +8.8%
EU M3 (May) 3m y/y +8.7% +8.7%
EU Private sector lending (May) y/y +11.4% +11.3% last
NO Retail sales (May) m/m +3.7% +0.6%
NO Unemployment rate (Jun, nsa) 2.6% 2.6%
GB Consumer credit (May) +£1.2bn +£1.1bn
GB Net lending secured on dwellings (May)+£9.3bn +£9.1bn
GB Mortgage approvals (May, sa) 117k 110k
* 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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