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Thursday July 6, 2006 - 11:29:58 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• EUR-USD direction likely to be difficult ahead of Friday’s employment report.
• Slight downside risk today on the basis of possible ECB disappointment – but latter is a close call.
• UK MPC announcement, US non-manufacturing ISM and pending home sales also feature.

Market Outlook

Concerns about Korean missile tests, oil price strength, uncertainty over the ECB meeting and the introduction of upside risk to Friday’s US employment report all combined to negatively affect global market sentiment yesterday and this also helped the USD. The investment horizon seemed to clear a little after last week’s FOMC meeting and steady core PCE price index, suggesting the likelihood of a period of at least a limited recovery in high-risk assets like equities and emerging currencies. There is still a fair chance of this happening and a number of such markets have recovered this morning, but some nervousness will remain ahead of Friday’s US employment report. Markets will also keep an eye on the oil price after benchmark NYMEX crude briefly touched fresh highs yesterday.

The data item that got the market excited yesterday was the ADP estimate of private sector employment, which came in at +368k. ADP, which provides payroll services, takes a sample (14mln employees) of its own data and uses this as a basis for estimating total private sector employment, claiming to have a 0.9 correlation with % m/m changes in the private sector element of official non-farm payrolls. Looking at recent incidents of ‘large’ ADP numbers the evidence is split on what it means for this month’s official data. In February, for example, the ADP estimate was +342k, with official total payrolls at +200k and official private sector payrolls at +168k, while in November last year the ADP estimate was +362k compared to official payrolls of +354k and private sector payrolls of 326k. Overall, it does suggest an upside risk to Friday’s number, but not conclusively so.

If Friday’s data does turn out strong (and the market will be hoping that any payroll strength is not accompanied by strength in hourly earnings) it is important that other key indicators show signs of moderation. So far this week, the ISM manufacturing number has done just that and the ISM for non-manufacturing is due today (not yesterday as previously indicated). The ISM for non-manufacturing has not shown many signs of weakness so far, having been at or above 60 for the past four months, but a softer number (not too soft) would be welcomed today. Pending home sales are also due (see below).

Amidst all of this uncertainty about the US interest rate backdrop, the ECB announces its latest policy decision today and once again it is a close call. A rate hike would clearly be justified but it is not clear that a majority of the council will view it this way. On balance the risk is that the EUR will once again end up disappointed (see below for full preview). 1.2675-95 is the main short-term support area on EUR-USD – resistance at 1.2750, 1.2795 and 1.2840/50. However, major movement looks unlikely until Friday’s employment report, which could be significant for global market sentiment and the USD. Note that if the ECB is not that hawkish and payrolls fail to come in strong, this may still turn out to be supportive for EURUSD as such events will help to promote better sentiment about high-risk assets. It is this kind of ‘mixed message’ environment that will likely make direction difficult for major FX in the weeks ahead. Equities and emerging markets have greater scope for movement.

Mixed data out of the UK today ahead of the MPC meeting outcome, with HBOS reporting a 1.2% m/m fall in house prices and UK manufacturing output marginally ahead of expectations. Q1 data on mortgage equity withdrawal was also released, totalling £12.5bn, up from a revised £12.1bn in Q4 (originally put at £11.8bn). The ongoing recovery in this series lends support to the thesis about households switching credit card and other high-rate debt into mortgage debt. Over the past 12- months there has been a marked deceleration in the rise in credit card debt, with the rate of growth over the past three months the lowest seen since 1996.

Day Ahead
UK - the MPC make their latest policy announcement, although an unchanged rate outcome is widely expected. Currently, there is little appetite for any policy change and this could also persist through the August Inflation Report meeting. Amongst other things the MPC will want to see how asset markets fare in the weeks ahead as well as how spending develops once World Cup distortions have left the data. The NIESR estimate of GDP is due tonight.

Eurozone – the ECB meeting is the major focal point. With interest rates very low and most indicators relating to inflation, liquidity growth and economic activity showing strength, a rate hike could be justified at any time and on this basis alone there is a risk of a move. Indeed, a further hike in rates would seem the sensible option.

However one gets the sense that not all members of the council are in agreement on how best to proceed. Clearly, there is a consensus on the basic need for further rate rises, but there appears to be disagreement on the extent and timing of such moves. The hawks have been mostly prominent over the past couple of weeks or so, although it is not clear that they carry a majority on the council. The unwillingness of Trichet to say anything definitive also suggests a lack of consensus. Unchanged rates is probably the most likely outcome today, but there is a risk of a move if some of the doves are won over by recent data developments and the more stable conditions currently seen in the equity market.

The market seems to be looking for an unchanged rate outcome and a hawkish comment about the likelihood of a move in August. However, it is not clear that the two can go together. If the majority decides against a rate hike today, can they go on to signal that a move will probably be seen in August? This would be odd, as it would beg the question about why they are waiting for another month and not hiking now. If rates are left unchanged today, the only acknowledgement about the possibility of a rate hike in August may be confined to Trichet noting that rates can in theory be altered at the August 3 meeting, even though it is held by conference call and has no scheduled press conference. He will also likely reiterate that further tightening is likely over time, but most important of all will be whether or not he uses the term vigilance. The market will probably take this as the biggest clue about what may happen in August.

US – the non-manufacturing ISM survey is due today (see above) along with the latest report on pending home sales. Pending home sales have been falling steadily since Q3. Apart from the 0.9% m/m rise seen in January, this series has fallen in every month since August and by a cumulative 12.8%.

Data/event EDT Consensus*

GB MPC rate announcement 07.00 4.5%
US Challenger layoffs (Jun) 07.30 53.7k last
EU ECB meeting outcome 07.45, press conf 08.30 2.75%
US Initial claims (w/e Jul 1) 08.30 315k
US Continuing claims (w/e Jun 24) 08.30 2409k last
US ISM non-manu (Jun) 10.00 59.0
US Pending home sales (May) 10.00 -0.4%
CA PMI (Jun, nsa) 10.00 65.0
GB NIESR GDP (3mths to Jun) q/q 19.01 +0.6% last

Latest data Actual Consensus*
US ABC consumer conf (w/e Jul 2) -9 -10 last
GB HBOS house prices (Jun) m/m -1.2% +0.1% last
GB Ind prod (May) m/m +0.3% +0.4%
GB Manu output (May) m/m +0.5% +0.3%
GB Mortgage equity withdrawal (Q1) £12.5bn £12.5bn
* 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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