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Wednesday August 18, 2004 - 10:43:16 GMT -

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Published By: Boris Schlossberg, Fundamental Analyst

Denying the Obvious

How many times must the cold, hard reality of bleak economic data slap USD bulls in the face before they finally accept it? Instead of hitting a “soft patch” the US economy seems to be teetering on the edge of a black hole with deflation and recession looming inside. The lower than expected CPI number came as no surprise to us as data world-wide - not just in US - has consistently shown complete absence of pricing power with secular deflationary effects of China and India continuing to exert their influence on the world economy. The bizarre irony of a negative CPI caused by lower gasoline prices as oil hits daily record highs was well explained by our colleague in last night’s US wrap up note and is worth repeating here. The gasoline surplus is temporary and should disappear by September, at which point the US consumers will be faced with the unenviable choice of paying more for fuel or buying less of other goods as their wages remain stagnant. It is this inability of the US economy to produce jobs and corresponding wage increases -- that is the driving force behind the deflationary pressures that persist throughout the system.

The Fed, by trying to stifle the inflationary impact of oil prices, as usual is focusing on the wrong problem. Through its single-minded desire for higher rates it may tip the country into a recession. Virtually every economic statistic of the past month has disappointed to the downside, including yesterday’s Industrial Production and Capacity Utilization both of which printed below expectations. More importantly still, forward data continues to show a contraction in trend. The Redbook weekly retail sales have reported a 2nd negative week in a row implying that Retail Sales for August may be tepid at best. Asha Bangalore of Northern Trust observes that the Empire State Manufacturing Survey which showed a precipitous drop to 12 from 32 expected, has a 90% correlation with the ISM number. According to Bangalore, this months decline in Empire could have a very negative affect on the upcoming national ISM report.

Yet while the dollar is weaker against the yen finally breaking the 110 handle in the European session, it is maintaining strength against the euro. Why? One simple reason is that most European market players are on the beaches of St. Tropez happily ignoring the depressing drumbeat of data. The other, perhaps much more important explanation is that many traders are reluctant to establish new euro long positions at these levels without additional supporting economic data. As the euro trades to the 1.24 handle it approaches the natural top of its long term range against the dollar. Tonight’s mixed Euro-zone data (FRF Trade Balance better this month but last month revised downward, CPI lower than expected) offers little guidance for the session that will have no US data to report. We may even test the 1.2300 handle as dealers probe stops in what is shaping up to be a directionless day. Yet for players looking longer term, the persistent stream of negative US eco data will eventually catch up with the dollar and may even make Goldman Sachs’ quixotic 1.36 year end target on the pair seem like a reasonable price.

Key Overnight Developments

- EUR CPI lower than expected (-0.2% vs. –0.1%) as consumer demand stays muted
- GBP MPC vote was 9-0 and tone was neutral as BOE viewed risks as balanced.

FX Spot Overnight
- EUR trades down to 2315 but stabilizes after CPI data
- JPY breaks the 110 handle as trades start to focus back on fundamentals
- GBP flutters down to 8240 on worries of dovish MPC but recovers 8270 after statement turns out to be neutral
- CHF inversely shadows the EUR trading up to 2470

Upcoming Events
12:30GMT – (8:30 AM EST) CAD Int'l Securities Transactions (June) Expected at –C$0.5Bn, Previous C$1.3Bn

Economic Data Release Recap
Currency GMT Release Actual EST Previous Comment
FRF 6:45 Current Account (Jun) -€705m -€700.0m -€700.0m CA deficits appear to have stabilized
FRF 6:45 Trade Balance (Jun) -€304 -€530m -€263m Better than expected but last month revised upward to -€336m
GBP 8:30 MPC Aug Meeting Minutes 9-0 vote but the tone of notes is neither dovish nor hawkish as BOE notes risks are balanced
EUR 9:00 Euro-Zone CPI m/m (Jul) -0.2% -0.1% 0.0% Decline in IT and telecom leads the way
EUR 9:00 Euro-Zone CPI y/y (Jul) 2.3% 2.4% 2.4% Core drops to 1.8% below ECB 2% target


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