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Wednesday October 18, 2006 - 10:38:00 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• USD struggling to respond to data strength – more EUR-USD consolidation due.
• USD-JPY corrective potential would extend below 118.31.
• GBP and UK rate expectations firmly underpinned by yesterday’s ‘strong’ CPI data – mixed news from today’s labour data/MPC minutes.
• US CPI features today.

Market Outlook

Lots of noise in yesterday’s US data – stronger core PPI, weaker industrial output, rise in the NAHB housing index – but none of it was that significant. The core PPI trend is unclear after recent volatility (one strong month after two weak months), while the NAHB housing rise comes after months of straight-line weakness. Weekly store sales data were actually quite strong and this may raise expectations about lower energy prices boosting retail sales in October.

What is striking so far this week is the USD’s inability to respond to positive data, suggesting that the main thrust of the upmove is over for now. US rate expectations have adjusted to neutral and some excessive EUR-USD longs have been pared back. Some consolidation looks likely in the short-term, but 1.2580- 1.2610 should cap EUR-USD initially. It should bottom out over the next couple of weeks, although there is some uncertainty about whether it needs to dip a little lower first (to 1.2350- 1.2400 rather than the 1.2460-90 area that has held it so far).

Positional adjustment has also been supporting the JPY, with yesterday’s USD-JPY break below 118.80 a significant development. However, the o/n low at 118.31 needs to break to open further short-term corrective risk to 117.40-50. EUR-JPY has some risk down to the 147.70-148.20 area. The JPY was boosted at one point overnight by a media report saying that the BoJ would increasingly monitor so-called JPY carry trades, although the BoJ downplayed the significance of the report. The minutes of the September meeting also reiterated their belief that business investment could become overheated by the low level of interest rates – another sign that they would like to raise rates again by year-end.

GBP remains firm after yesterday’s CPI data, which revealed some worrying trends in some of the core price categories. This morning’s releases have been slightly mixed. MPC minutes serve to underpin the rate hike risk in the UK over the next couple of quarters, although labour market data was softer than expected, with unemployment edging up further and ex-bonus earnings softer (see chart).

There was a 7-2 vote in favour of leaving rates unchanged at the October meeting with the two dissenters arguing in favour of a 25bp rate hike. Of more significance is that these two dissenters also happen to be the two new members of the MPC – Besley and Sentance – and this may leave the market with the impression that the MPC has become a more hawkish entity since their arrival. The minutes noted that for most members the decision had been a finely balanced one. Those in favour of a rate hike argued that since August most evidence had suggested a continuation of above-trend growth and to act on rates now would reduce the possibility of having to make a larger increase later on. They also cited evidence from the Bank’s own regional surveys, suggesting that firms appeared to be more willing and able to increase prices.

Other members agreed with most of these arguments but thought there was no pressing need to raise rates. They also thought that such an outcome would trigger a further rise in overall rate expectations and that the extra degree of tightening this would represent was not currently warranted. Others thought that more time was needed to assess the impact of the August rate rise as well as issues related to pricing behaviour. One (Blanchflower) expected the labour market to weaken further and that the degree of spare capacity was larger than thought back in August. It is the size of this latter camp that is the main issue for those looking for two rate hikes.

However, yesterday’s CPI data is new information for the MPC and may have bolstered the hawkish case. That data needs to be monitored, but as it currently stands the odds in favour of a Q1 rate hike (in addition to a 25bp move in November) have increased significantly and this is something we were not previously factoring in. EUR-GBP looks set to test the downside further in the short-term but 0.6685 (Sept low) needs to break to open risk to 0.6610-30.

Day Ahead
US – the stakes on today’s CPI have been raised a touch by yesterday’s strong +0.6% jump in core PPI, although the latter did come after two very weak outcomes (-0.4% Aug, -0.3% Jul) so the underlying trend is unclear. Core CPI has been softer over the past couple of months at +0.2% after four outcomes of +0.3%. However, it is worth keeping an eye on the breakdown of the data and especially the role played by the controversial “owner equivalent rent” category. This category was a key factor behind the strength in core CPI earlier in the year, but lapsed last month.

Data/event EDT Consensus*

Oil OPEC meeting (2 days)
US CPI (Sep) m/m 08.30 -0.3%
US CPI core (Sep) m/m 08.30 +0.2%
US Housing starts (Sep) 08.30 1640k
CA Leading indicator (Sep) m/m 08.30 +0.2%

Latest data Actual Consensus*
US NAHB housing index (Oct) 31 30
US ABC consumer conf (w/e Oct 15) -7 -8 last
GB MPC minutes (Oct 4-5 meeting) 7-2
GB Claimant count (Sep) +10.2k 0.0k
GB ILO unemp 3m ave (Aug) m/m +45k +93k last
GB Average earnings (Aug) 3m y/y +4.2% +4.4%
GB Earnings ex-bonuses (Aug) 3m y/y +3.6% +3.7%
EU Trade balance (Aug, sa) -€5.5bn -€4.0bn
* Consensus unless stated
(ex-bonuses, 3m y/y)

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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