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Thursday November 2, 2006 - 11:29:33 GMT
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Forex: Mellon FX Daily - U.S. Edition

Key Points
• USD a little steadier overnight - yesterday’s ISM will limit any recovery.
• Friday’s US data will be critical.
• ECB meeting today’s main feature although Trichet is unlikely to surprise.
• AUD falls in Asia on weaker sales data, bounces back in Europe – RBA rate hike still on.
• NOK up on Norges Bank message but true NOK confidence will depend upon oil.
• US unit labour costs also feature today.

Market Outlook

Yesterday’s weaker than expected ISM manufacturing data provides further evidence in favour of a US slowdown, although it is too early to conclude that this is the beginning of the type of slide seen in the 2nd half of 2000. During 2000 the manufacturing ISM fell from an average of 55.8 in Q1 to 53.1 in Q2, 50.7 in Q3, 47.0 in Q4 and 41.7 in Q1 2001. Friday’s releases – ISM non-manufacturing and the employment report – will be watched closely.

One issue about evidence of softer activity is that it can also affect the FX market’s interpretation of inflation data. Strong inflation numbers in combination with solid activity data are clearly more supportive for the USD than strong inflation and weak activity data. The latter merely evokes a picture of an economy ill equipped to cope with the tighter policy implied by the inflation threat. We may not have reached this point just yet, but any strength in today’s unit labour cost data may trigger ‘stagflation’ type talk in the market and this will not necessarily be positive for the USD.

The USD actually stabilised a little in Asia, led by USD-JPY, perhaps on some minor position closing by very short-term accounts ahead of the long weekend – Japan is on holiday tomorrow. However, the USD weakened again in Europe following comments from Watanabe suggesting that there was no reason for the JPY to weaken further. Moreover, the overriding positional risk should still be a supporting factor for the JPY in the short-term. How USD sentiment plays out during the rest of this week will be affected by Friday’s US data and today’s ECB meeting. The latter is previewed below although it is unlikely to prompt any major change in market rate expectations.

The AUD fell back a little in Asia, in part because of the slightly firmer USD, but also because of the weaker than expected retail sales data (+0.1% as opposed to +0.5% expected). However, it bounced back well in Europe after having moved close to support at 0.7700. The sales data is not weak enough to derail hopes of an RBA rate hike next week, although unless there is further generalised USD weakness 0.7800 may be difficult to take out during this attempt.

Yesterday’s Norges Bank meeting did advance a more hawkish message on future tightening, although they made it clear that this would not necessarily equate to hikes at every meeting. There are six rate announcements between now and the end of June next year and a fair benchmark profile should be 25bp rate hikes at four of those meetings. This would leave their key rate at 4.25% and much of this is already in the money market – 3- mth money is priced at 4.35% for June. On the basis of rate expectations alone EUR-NOK would probably be a lot lower and eventually this should play out – sub-8.00 still a possibility in the next few months. However, the market needs to have more confidence that oil has reached a floor before true NOK confidence returns.

Day Ahead
Eurozone– the ECB are likely to leave rates unchanged but the market will be looking for the usual signal to back up current sentiment about a 25bp hike in December i.e. the use of the word vigilance. Other than this an unchanged message seems likely from Trichet – namely that progressive withdrawal of monetary accommodation will continue as long as key indicators develop in line with their forecasts. One could argue that recent CPI numbers have been softer than planned, but as this is ‘oil related’ the ECB will also see it as a boost to economic activity. Trichet is unlikely to be drawn too much about what will happen in 2007, although more recently ECB officials have not been actively discouraging talk of higher rates next year. He is also likely to repeat his comments from last month’s meeting about the German VAT hike not being that significant. Overall, his comments are unlikely to disrupt the notion of another rate hike next year.

US – Q3 productivity and unit labour costs are due and labour costs caused some controversy when the final reading for Q2 was released last month. In terms of q/q seasonally adjusted annualised rates Q2 was revised up to +4.9% from +4.2% and Q1 up to +9.0% from +2.5%, with the latter due to hourly compensation being put at +13.7% from +5.3% originally. These were big numbers – so big in fact that there was some cause for scepticism. One could argue that the scale of these rises increases the risk of core inflation staying high. However, if they are ‘bonus’ related as oppose to ‘wage’ related they are more likely to be payments that companies can afford and by definition should be less of an upside pressure on end-pricing. Nonetheless, the market will again be sensitive to any unusual outcomes.

Data/event EDT Consensus*

US Challenger layoffs (Oct) 07.30 +100.3k last
EU ECB meeting outcome 07.45, press conf 08.30 unch
US Productivity (Q3, 1st est) saar 08.30 +1.2%
US Unit lab costs (Q3, 1st est) saar 08.30 +3.5%
US Initial claims (w/e Oct 28) 08.30 310k
US Continuing claims (w/e Oct 21) 08.30 2449k last
US Factory orders (Sep) m/m 10.00 +4.0%
US Fed’s Fisher spks on econ 12.00

Latest data Actual Consensus*
JP Monetary base (Oct) y/y -21.3% -21.8%
AU Retail trade (Sep) m/m +0.1% +0.5%
AU Trade balance (Sep) -A$0.6bn -A$0.2bn
CH CPI (Oct) y/y +0.3% +0.7%
IT PMI manu (Oct) 56.2 54.8
FR PMI manu (Oct) 56.3 56.3
DE Unemployment (Oct) -67k -23k
DE Employment (Sep) +24k +34kR last
DE PMI manu (Oct) 58.2 58.6
EU PMI manu (Oct) 57.0 56.8
NO Unemployment rate (Oct, nsa) 2.2% 2.3%
* 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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