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Wednesday August 4, 2004 - 10:38:02 GMT -

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The High-Yield Edge
Tonight’s decision by RBA to leave rates unchanged at 5.25% along with tomorrow’s expected 25bp rate hike from BoE brings the high yield currencies back into focus and allow us to examine once more the status of the carry trade. Presently the Kiwi trades at 475bp spread to the dollar, the Aussie at 400bp spread and the pound at a 325bp rate differential. Should BoE raise rates on Thursday as expected, the cable premium to the greenback would stand at 350bp before the FOMC meeting on August 10th.

The Fed seems determined to raise rates 25bp to 1.5% at the August meeting. Yet we have long argued that instead a “measured” response, the Fed interest rate tightening policy going forward is likely to be “non-existent” for rest of the year. Why? With core PCE running at only 1.5% y/y rate, China and India continuing to exert structural deflationary pressures on US and wage growth practically non-existent, the Fed’s only inflationary stress comes from oil which may have peaked for now. More importantly, with over 40% of all US corporate profits generated by the financial sector – an industry highly depended on low rates -- and with yesterday’s dismally low US consumer spending report even a 50bp additional Fed hike could have chilling implications on US economy. If the interest rate differential will not materially compress in the near term, then the market should soon again favor the high yield currencies. For now however, as USD rally persists, the carry trade profits could be found in the crosses such as the EUR/GBP, GBP/CHF and AUD/JPY.

The dollar rally seems destined to continue today as overnight Euro-zone data fuels USD bulls. Not only does German unemployment report 11K vs. 5K expected but previous month’s report is negatively revised from –1K to 2K unemployed. Overall, at 10.6% the German unemployment rate now stands at an 11 month high and experts forecast the rate to remain above 10% all the way through 2005 weighing heavily on the euro. The only reprieve comes from surprisingly strong EU retail sales (1.8% vs. consensus 1.2%) but if today’s US ISM Services number prints better then expected, the euro may pierce the 1.2000 handle finally shaking out the last complacent dollar bears.

Key Overnight Developments
- AUD RBS leaves rates unchanged as expected at 5.25%
- EUR German Unemployment disappoints at 10.6% vs. consensus 10.5 Services PMI also lower 55.3 vs.55.5 Retail up 1.8%

FX Spot Overnight
- EUR tests 2000 level but rebounds fast holding support so far
- JPY climbs back above 111 on Nikkei weakness
- GBP loses 8200 handle on profit taking receding terror risk
- CHF break 2800 once more as low inflation numbers drive dollar to 125 pip gain

Upcoming Events
14:00GMT – (10:00 AM EST) USD ISM Non-Manufacturing (July) Expected at 61.8, Previous 59.9
14:00GMT – (10:00 AM EST) USD Factory Orders (July) Expected at 0.5%, Previous –0.3%

Economic Data Release Recap
Currency GMT Release Actual EST Previous Comment
AUD 23:30 RBA Cash Target (Aug) 5.25% 5.25% 5.25% No comment from RBA as no change was expected
ITL 7:45 PMI Services (Jul) 58 58.2 - New business and outstanding orders both decline
FRF 7:50 PMI Services (Jul) 55.1 58.1 57.9 Employment and new orders decline
DEM 7:55 PMI Services (Jul) 53.9 52.6 - German services rise above expectations led by travel
DEM 7:55 Unemployment Change (Jul) 11K 5.0k -1.0k No evidence yet that export led recovery is creating jobs as even previous month was revised upward to 2K
DEM 7:55 Unemployment Rate (Jul) 10.6% 10.5% 10.5% Worst in 11 months. Experts expect rate to remain above 10% for all of 2004 and 2005
EUR 8:00 PMI Services (Jul) 55.3 55.5 55.3 Still expansionary but belowexpectations
GBP 8:30 PMI Services (Jul) 56.2 56.5 56.8 Just slightly worse then expected showing continued UK strength
EUR 9:00 Retail Trade m/m (Jun) 1.8% 1.2% -1.3% Rebound in German and French Sales leads to gains


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