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Wednesday May 5, 2004 - 21:10:19 GMT -

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Stronger US Non-Manufacturing ISM

Daily Forex Report 05-05-04

· Stronger US Non-Manufacturing ISM
· Switzerland Upgrades GDP Forecasts
· RBA Leaves Rates Unchanged at 5.25%


The euro extended yesterday’s gains as the market digested the implications of the most recent FOMC statement. Elaborating on the Fed’s new favorite word “measured,” we want to clarify and emphasize that should the Fed raise rates, they will be delivering a 25bp hike and not a 50bp hike. Additionally, hiking in one month does not automatically suggest that the Fed will be hiking the following month. The Fed will be keen to avoid repeating the disastrous effects of the too aggressive tightening cycle in 1994. In 1994, the Fed surprised the market by raising rates 250bp in 12 months, causing the bond market to collapse and yields surging from 5.4% in September 1993 to 8. 0% in November 1994. Of course, inflation is less of a concern now, however, the striking parallels of low interest rates, a rebounding economy and a weak dollar has led many market participates to believe that the Fed is indeed concerned about preventing a repeat of 1994. Higher unemployment in Germany failed to dent the euro’s rise. Tomorrow, the ECB will leave rates unchanged, and we will look to see whether the ECB gives any fresh signs of a possible summer easing.


US non-manufacturing ISM increased from 65.0 to 68.4 in April. Growth in both the service and manufacturing sectors have been very impressive, beating some of the most optimistic expectations. In what may be a foreshadow to Friday’s non-farm payrolls report, an employment index released by Hudson Global, rose to year to date highs. The number of workers who reported their firms are increasing hiring rose to 39%. Meanwhile, in Switzerland, consumer prices increased from 0.3% to 0.8%. This is another confirmation that Switzerland’s economy is improving and deflation is no longer a concern. As a result of the generally improving economy, Switzerland’s State Secretariat for Economic Affairs upgraded their GDP forecasts to 1.8% for 2004 and 2.3% for 2005.


The Bank of England is widely expected to raise rates by 25bp tomorrow. The housing market data from HBOS and the Financial Times for the month of April is a further confirmation that the economy needs another rate hike. As we have previously mentioned, we have yet to see the effects of the last 2 interest rate hikes on housing and consumer spending. The HBOS house price index has experienced the fifth consecutive month of rising year over year increases. If the Bank of England raises rates tomorrow, the next step would be to look at the accompanying comments for any hints of the central bank’s future intentions. Although we doubt that this will be an end to their tightening cycle, the BoE will most likely continue to emphasize their gradual approach.


After rallying to a high of 111.07 on April 29th, USDJPY is finally acting appropriately as the yen resumes its appreciation against the dollar. Japanese fundamentals continue to improve while the Bank of Japan is taking active measures to underpin Japanese economic growth. Although deflation is beginning to improve, the BoJ remains committed to maintaining an accommodative monetary policy until deflation is overcome.

As expected, on April 6, 2004 the RBA left the cash rate unchanged at 5.25%. Consecutive rate hikes at the end of last year appear to be having their desired effects in slowing the economy. Recent data show some cooling in the housing market, with approvals for new home loans falling to an 11-month low in January. In addition, gains in both retail sales and employment have decelerated over the quarter. Despite rates remaining below the Bank's supposed "neutral" 5.50% - 5.75% range, consensus estimates do not forecast further tightening before the second half of 2004, given policymaker concerns about the effects of AUD strength on exporters. With inflation tame and the housing market slowing, the Bank can afford to adopt a wait-and-see approach while maintaining its tightening bias.


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