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Tuesday January 16, 2007 - 11:27:36 GMT
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Mellon FX Daily - U.S. Edition

Mellon FX Daily
06:00 EST January 16, 2007

Key Points
• Media speculation about a BoJ rate hike continues, although given the fragile case for the move, the JPY is not seeing much benefit.
• EUR-USD remains steadier after last week’s losses– ZEW better.
• GBP eases back as 3% CPI fails to fuel rate hike expectations any further.
• NY Fed index, BoC policy announcement, NZ CPI feature today.

Market Outlook

UK CPI came out stronger than expected at +3.0% y/y for Dec, although this was just short of the 3.1% that would have forced the BoE governor to write a letter to the Treasury explaining why there had been a 1%-plus deviation from the 2% target, what they intended to do about it and how long it was expected to last. Indeed, in some ways it is perhaps unfortunate that they did not have to write a letter as this would have provided them with a fairly high profile opportunity to highlight why much of the recent CPI strength should prove to be transitory.

These include the negative base effects relating to the likelihood of last May’s very sharp rise in electricity and natural gas prices not being repeated. Furthermore, natural gas prices should fall in the second half of the year as much lower wholesale prices are passed on, which should help to push y/y rates down further. Food prices may also struggle to match the incremental m/m rises seen since May this year (food price inflation had risen to 5% in November compared to +1.1% in May), suggesting the possibility of more negative base effects for the CPI y/y rate. The step change to university fees adopted in October (0.12% on the CPI y/y rate) will not be repeated this year.

Core CPI remains well below the total CPI rate (see chart), although with core CPI (currently at +1.8%) also at multi-year highs and rising the MPC are clearly in no mood to take any chances. Tomorrow’s average earnings data will also be critical in determining sentiment about the pressure on ‘core’ inflation. As it turns out, today’s CPI outcome will still be seen as the prime reason for last week’s surprise rate adjustment and at this point that is all the market was looking for – an explanation for the surprise. Of course, the MPC is supposed to set policy with regard to hitting the target over the medium-term and they use a frame of reference of about two years in this regard. In this sense, responding to short-term or transitory moves in CPI is not straightforward, which again demonstrates the ‘take no chances’ approach to CPI currently being adopted. They can afford to employ such tactics given that most measures of economic activity remain solid overall. However, whether this will equate to a further 25bp rate hike by the end of Q1 (as the market is currently discounting) and another 25bp adjustment in Q2 (the market is almost discounting that as well) is not clear. There is clearly a risk that the latest move (the third since the summer) will have a negative impact on the economy. For now, GBP gains have probably been seen already and some further significant data strength will be required to prevent a rebound in EUR-GBP back up towards 0.6650. Support is at this morning’s low of 0.6577 ahead of the 2004 low at 0.6545.

Speculation continues to develop in the Japanese media about the likelihood of a BoJ rate rise on Thursday, although the fragile case for a move is preventing any boost for the JPY. Recent talk suggests that Fukui and other senior BoJ officials are currently sounding out board members about which way they are leaning and that if a majority is in favour of a hike, such a move will be proposed. The slight improvements seen in the CPI and consumer spending data released in late December are being cited as factors that have helped to reduce the uncertainty felt at last month’s meeting. Furthermore, as noted yesterday, the fact that a majority of economists now expect the move provides the BoJ with an opportunity to act without causing major market fallout.

However, the media is also quoting one BoJ official as admitting that a split decision could be seen, which would reflect the question marks over the justification for a rate hike at this juncture as well as the general lack of power behind the Japanese interest rate story. Even if rates are hiked on Thursday and this is by no means a done deal, the market is unlikely to expect a further move until after the Upper House elections in July. Recent comments from government officials also suggest that they are strongly against a hike this week and there has been speculation that they will attempt to veto the decision, although this seems unlikely.

One option for the BoJ would be to raise rates by just 15bp, with such smaller increments being seen as a genuine attempt by them to placate the concerns currently felt about the strength of the current move away from the deflation problems of the past decade. Whatever happens on Thursday, it seems unlikely that the JPY will be able to shake off its low-yield status.

EUR-USD remains on a slightly firmer footing compared to Friday (helped this morning by a stronger ZEW survey) and there is likely to be some hopes in the market that a base has been found after the recent correction. The low on Friday (1.2867) equated to a line drawn through Jun, Aug and Nov highs – this line also being the breakout trigger for the upmove seen in November. However, position liquidation pressure could easily return if the US data shows any sign of strength this week.

Day Ahead
US – the NY Fed survey is due today and this has been fairly strong in recent months, in contrast to the more subdued showings in the ISM and Philly Fed reports. For these reasons the market will want to see more than today’s data before casting further judgement on the state of the manufacturing sector. The Philly Fed survey is due on Thursday.

Canada – the Bank of Canada are likely to leave rates unchanged today and the main focus will be on the accompanying statement to see whether they are placing more weight on the prospect of slower activity. Some of the data out of Canada has remained poor (retail and manufacturing sales), while employment has been strong and the latest export data was also slightly better. At its last meeting on Dec 5 the BoC highlighted the US economy as a key downside risk for the Canadian economy and while US prospects have improved slightly since then, recent comments from Dodge seemed to show additional concern about such factors. On January 8 he said that the weakness in automotive and housing sectors in the US were a problem for Canada. Overall, while they will likely note that some weak signs remain, a major downgrade of their basic view of the situation seems unlikely. However, there may be more comments about recent CAD weakness being justified given the declines in key commodity prices. More information on their views will be revealed in Thursday’s Policy Update.

The CAD has currently lapsed into correction mode, which is not that surprising given the record spec CAD shorts reported for last Tuesday in the latest IMM data. The tone of today’s statement will be critical to how this now develops. 1.1740 needs to be won back to raise the risk of another test of 1.1800, while support is at 1.1575-1.1600.

New Zealand – Q4 CPI data tonight will need to be soft to neutralise the threat of a rate hike on January 25. The headline y/y rate is likely to fall considerably (to +2.8% from +3.5%) due to weaker fuel prices, although the RBNZ is already anticipating this and has indicated that it will look beyond such energy driven volatility. There are a whole gamut of core measures the RBNZ looks at and these are ranging from +2.7% to +3.6% at the current time. How these perform will influence the following week’s rate decision, while Friday’s retail sales will also be significant. The strength of household demand is a key factor behind RBNZ concern over upside risks to inflation.

Data/event EDT Consensus*

US Chain store sls (w/e Jan 13) w/w 07.45 +0.7% last
US NY Fed index (Jan) 08.30 19.7
US Redbook sls (w/e Jan 13) m/m 08.55 +1.7% last
CA BoC policy announcement 09.00 unch
NZ CPI (Q4) q/q 16.45 -0.1%
NZ CPI (Q4) y/y 16.45 +2.8%
US ABC consumer conf (w/e Jan 14) 17.00 -5 last
JP Current account (Nov, sa) 18.50 ¥2.1trn
JP Consumer confidence (Dec) 00.00 47.2

Latest data Actual Consensus*
JP Domestic CGPI (Dec) y/y +2.5% +2.5%
JP Dom CGPI final goods (Dec) y/y -0.1% 0.0% last
GB RICS house prices (Dec) 37% 45%
JP Ind prod (Nov, final) m/m +0.8% +0.7%
GB CPI (Dec) y/y +3.0% +2.9%
GB CPI core (Dec) y/y +1.8% +1.7%
GB RPIX (Dec) y/y +3.8% +3.6%
GB RPI (Dec) y/y +4.4% +4.3%
DE ZEW expectations (Jan) -3.6 -10
EU ZEW expectations (Jan) -1.8 +2
* 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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