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Thursday July 20, 2006 - 10:30:45 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• Bernanke offers a ‘golden scenario’, with slightly more tolerance of ‘transitory’ inflation.
• This should see more market relief in the short-term and a weaker USD, but risks clearly remain.
• A calmer global markets environment may see some rebuilding of optimism in the AUD.
• UK retail sales stronger than expected.
• US Philly Fed survey features today.

Market Outlook

Even with a fairly nasty core CPI number, Bernanke was still able to generate relief in global markets and this may extend a little further in the short-term. However, the tone of key data releases in coming weeks will be significant in determining how far this extends and how long it lasts.

There were two significant messages from Bernanke yesterday, both of which had been touched upon in the June 29 FOMC statement. The first was the optimism about the achievement of inflation control without any massive deceleration in growth. In this regard he has expressed confidence in the ‘soft’ as opposed to the ‘hard’ landing feared in the market. Second (and perhaps more significant) is that the Fed seems to be saying that it will be tolerant about ‘transitory’ inflation strength and that it will not be blindly pursuing the achievement of sub-2% inflation at the expense of economic growth. This was clearly evident in their projection for core PCE price inflation at the end of next year (2%-2.25%). While this is lower than the 2.25%-2.5% seen for end 2006, it remains above 2%.

Such projections are usually seen as ’targets’ given that they depend upon ”appropriate monetary policies” so to have core PCE price inflation staying above 2% is an acknowledgement that policy need not be too penal (see yesterday’s note Bernanke testimony review for more). However, the tolerance of some ‘transitory’ rise in inflation will clearly have its limits and the Fed will find it difficult to ignore any excessive moves that affect inflation expectations, as Bernanke also acknowledged yesterday.

This is why the data releases of the next few weeks – core PCE prices, ISM surveys and the employment report – will be significant in influencing sentiment about the outcome of the August 8 FOMC meeting. However, having outlined a scenario of confidence about inflation moderation and some tolerance of ‘transitory’ inflation strength, they may feel obliged to leave rates unchanged as long as there are no nasty surprises in the data. Also by tying inflation tolerance in part to the way inflation expectations develop, Bernanke is smartly shifting some responsibility back on to the bond market. If inflation starts developing in an alarming manner or the market has no confidence in growth moderation, bond yields (and hence inflation expectations) will rise and the Fed will likely respond to such concerns by hiking rates.

EUR-USD has more room to recover in the short-term, but there will be some resistance around the 1.2660-70 area. However, while Bernanke appears to have provided some clarity on how the Fed will approach policy, there is much room for sentiment to develop either way and this is not an environment that is conducive to dramatic direction (or positioning) on the majors. A broad 1.24-1.30 range looks like holding for some time. However, the settling of some of the concerns in global markets could allow the market to pursue other themes with slightly more confidence.

The AUD is a case in point. Some position cutting has been evident in recent days – positions that had previously been taken up due to optimism about an RBA rate hike on August 2. This positioning may now start to be rebuilt. While the market may still want to see next Wednesday’s Australian CPI data the odds will still strongly favour an August rate rise. 0.7570 should be broken ahead of the RBA meeting.

More strong data out of the UK this morning, with June retail sales rising 0.9% m/m and the May increase being revised up to +0.7% from +0.5% previously. However, once again the World Cup appears to have had an impact, this time on the food category as oppose to the boost to electrical goods provided in
the May report. The ONS noted this as a factor behind the 2% m/m rise in food sales, which lay in contrast with the 0.3% rise in the non-food category. While spending has been solid overall in recent months, uncertainty remains about what will happen now that the World Cup is over. July and August data need to be seen. GBP strengthened on the news, although EUR-GBP remains above support at 0.6810-15 and a bounce is favoured.

Day Ahead
US – the Philly Fed index has been fairly steady in recent months and the latest NY Fed index released earlier this week also eased back after last month’s unusually strong showing. Also of interest today will be the showing on the ‘prices received’ category, a measure of prices of goods as they leave the factory gate as opposed to the more volatile input prices (‘prices paid’) that feature in the ISM survey. In recent months these have been in positive territory for both NY and Philly Fed measures, but are below the higher levels seen at various times over the past couple of years (see chart). FOMC minutes and Bernanke’s repeat testimony will also be monitored.

Data/event EDT Consensus*

CA Wholesale sales (May) m/m 08.30 +0.5%
US Initial claims (w/e Jul 15) 08.30 322k
US Continuing claims (w/e Jul 8) 08.30 2429k last
US Bernanke repeats policy testimony 10.00
US Lead indicators (Jun) m/m 10.00 +0.2%
US Philly Fed index (Jul) 12.00 12.5
US Minutes of Jun 28-29 FOMC 14.00
JP All-industry index (May) m/m 19.50 -0.4%

Latest data Actual Consensus*
FR Current account (May) €2.0bn -€2.1bn
IT Ind orders (May) y/y -0.9% -2.0%
GB Retail sales (Jun) m/m +0.9% +0.4%
GB PSNCR (Jun) £13.2bn £12.2bn
GB BBA mortgage lending (Jun) +5.6bn +£5.7bn 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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