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Tuesday July 18, 2006 - 10:31:49 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• Market uncertainty remains in place and with regard to the Middle East the focus will stay on oil prices.
• However, markets may otherwise want to wait and see key US events over the next couple of days.
• Strong data out of China will maintain expectations of further tightening.
• Eurozone/German ZEW expectations crash lower, but current conditions are higher.
• UK CPI again boosted by utility prices.
• US PPI, TIC portfolio data and the NAHB housing index feature today.

Market Outlook

The background of tension in the Middle East remains in place and the news flow also remains volatile. There were suggestions from Israel yesterday about the possibility of a speedy end to the offensive, but earlier this morning the deputy army chief said that it should be over within a few weeks. An Israeli cabinet minister then said that Israel might have to consider releasing some Lebanese prisoners if this would secure the safe return of the kidnapped Israeli soldiers. Another official said later that any release of Israeli soldiers should be without conditions. Equity markets are primarily concerned about how all of this affects the oil price and benchmark crude remains highly volatile given the erratic news flow but well off the highs seen earlier yesterday (currently $75.70 compared to $77.50 around the time of the European open).

As far as the FX market is concerned, current moves are generally about position cutting. Weakness in global markets does leave a risk of funds moving back into the USD investor base, but the primary cause for yesterday’s move was a clearing out of stale long EUR-USD positions after Friday’s closing break below 1.2660-70. There is a slight risk of this continuing today – next key level is the June 23 low at 1.2478 but for choice the market is likely to wait and see what appears from the key events of the next couple of days and this could see some modest stabilisation.

US PPI is due today, while US CPI and Bernanke’s policy testimony are scheduled for tomorrow. Anything friendly or dovish would be a boost for EUR-USD, while more strength and hawkishness would prompt a fresh move lower. Bernanke will not want to desert his anti-inflation credentials, but he may feel obliged to offer some soothing words for troubled equity markets. It is best to wait and see. More US earnings reports are also due at various times today (including IBM, Yahoo, Coca Cola, Johnson & Johnson) and these will also influence equity market sentiment, while the TIC portfolio data is a potential market mover for the USD.

This morning’s ZEW surveys showed a steep fall in the expectations component (knocking EUR-USD lower), but there was a sharp rise in current conditions. As usual one has to be a little careful of this survey as it canvases the opinions of investors and analysts rather than actual commercial businesses. To a large extent the responses will reflect the anxieties already evident in financial markets. The fact that ‘current conditions’ was so strong (highest since Feb 2001) highlights the current contrast between what is actually happening compared to what investors are now fearing about the future.

There was strong data out of China and while this may be seen as cause for some comfort given fears about a hard landing for the global economy, it will also maintain expectations about the likelihood of more Chinese rate hikes.

UK CPI was much stronger than expected at +2.5% from +2.2% and this boosted GBP. However, much of the strength was again down to utility prices (especially gas and electricity), which is less important from a long-term inflation perspective. Core CPI merely ticked up to +1.2% from +1.1%. The worry from the MPC’s point of view is that such elevated CPI readings may contribute to a faster pace of wage inflation, which in turn could put upward pressure on core CPI. However, in the absence of this there is every chance of the CPI y/y rate eventually heading lower. There are currently huge incremental m/m increases in utility bills being absorbed by the consumer and if these increments are not matched at the same stage next year, y/y rates will come down accordingly, possibly in spectacular fashion. This must be anticipated to a certain degree in the MPC’s 2-3 year CPI forecasts.

Other data out of the UK was also strong today, with the RICS house price survey showing the strongest rate of inflation for a couple of years. Retail sales and mortgage lending data are still to come this week but they will have to show a lot of strength to resurrect any hopes of an August MPC rate hike. Overall, a rate hike seems unlikely as the MPC is likely to want to see how sales develop in future months and they will also be mindful of recent developments in financial markets, which will be seen as negative for the economy. EUR-GBP support is at 0.6840-50.

Day Ahead
US – PPI, the TIC portfolio data and the NAHB housing index are all due in the US. Core PPI was up 0.3% m/m last month, although this came after 0.1% showings in each of the two months before that and the y/y rate remained at +1.5%. Overall, the PPI has not been as elevated as the core readings on CPI, but the market will clearly show sensitivity to the outcome. However, on the inflation front PPI is just a taster ahead of tomorrow’s key core CPI number as well as Bernanke’s current take on the status of the inflation threat.

The NAHB housing index has been very weak in recent months, last month falling to its lowest level for eleven years. This index is a combination of measures relating to current and expected sales and the number of prospective buyer inquiries. The TIC portfolio data is for May and will provide some useful information about the nature of investor behaviour (US and overseas) in what was a volatile month for global equity markets (strong initially but very weak thereafter). However, the USD reaction will be driven by the headline net flow number, which last month fell back to $46.7bn, the lowest seen since March 2005.

Data/event EDT Consensus*

US Chain store sls (w/e Jul 15) w/w 07.45 +0.2% last
US PPI (Jun) m/m 08.30 +0.3%
US PPI core (Jun) m/m 08.30 +0.2%
US Redbook sls (w/e Jul 15) m/m 08.55 -1.7% last
US TIC intl portfolio balance (May) 09.00 +$46.7bn last
US Fed’s Warsh speaks 09.00
US NAHB housing index (Jul) 13.00 41
US ABC consumer conf (w/e Jul 16) 17.00 -9 last

Latest data Actual Consensus*
GB RICS house prices (Jun) +28% +20%
JP Tertiary index (May) m/m +0.5% -0.3%
CN GDP (Q2) y/y +11.3% +10.4%
CN PPI (Jun) y/y +3.5% +2.7%
CN CPI (Jun) y/y +1.5% +1.5%
GB CPI (Jun) y/y +2.5% +2.3%
GB CPI core (Jun) y/y +1.2% +1.2%
GB RPIX (Jun) y/y +3.1% +2.9%
GB RPI (Jun) y/y +3.3% +3.0%
DE ZEW expectations (Jul) 15.1 35.0
EU ZEW expectations (Jul) 18.1 35.3
* 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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