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Forex Research - Mellon FX Daily - U.S. Edition

Mellon FX Daily 06:35 EDT

Key Points
• FOMC drops reference to possibility of additional policy firming, but still sees upside inflation risks.
• The move is comforting for equity markets – US rate expectations return to month lows.
• Future Fed policy will continue to depend upon the data, as will USD sentiment in general.
• AUD upside opening up further with 0.80 seemingly conquered.
• Brown bows out with another masterclass in fiscal chicanery. UK retail sales surpass expectations.
• South African current account fails to dent ZAR.

Market Outlook

The most notable change in the FOMC statement is the part relating to possible future policy actions. Whereas previously the FOMC referred to “the extent and timing of any additional firming that may be needed” they now state “future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” This means that a large element of the tightening bias has been dropped, although the paragraph on inflation shows that they still clearly see upside risk on price pressures. “Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.” Followed by “in these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.”

Equities rallied sharply on the news, reflecting the fact that the market now sees the Fed as being more ready to take account of the possible downside risks to growth (i.e. housing) – a renewal of the old ‘Greenspan put’ perhaps. However, policy will remain data dependent and an element of so-called tightening bias is still implicitly conveyed by their comments about inflation.

Indeed, another way of looking at the situation is to say that by responding in this kindly way (stabilising the equity market and helping bond yields lower) the FOMC is actually heading off one downside risk to growth i.e. the danger of the market talking itself into a recession. In so doing, they are actually reducing the risk of being put under pressure to cut rates, in what could still be an awkward situation due to a stubbornly high inflation backdrop.

The response in the money market was a more sober one. There was a softening in rate expectations, although only back to where they have been on other occasions over the past month or so. Rate expectations remain above the depths to which they sunk after the weak November ISM released in early December.

The USD has been left weaker against most currencies, except the JPY, which is not surprising as the support for equities means higher risk appetite (not good for the JPY). In the short-term, there is likely to be more in this USD move, although EUR-USD is likely to struggle to breach 1.35. Whether Fed rate cut expectations gather any further pace will depend upon the data in the coming months. Weaker data will leave the risk of an upside break on EUR-USD, while stronger data and a reining in of rate cut expectations would see EUR-USD pulling back to 1.30 and possibly lower. There is clearly room for volatility in response to the ebb and flow of the data, meaning that the data now perhaps holds even greater market relevance.

The JPY is likely to weaken further on the non-USD crosses in the short-term, while the development is good news for the AUD in its attempt to secure a position above 0.8000. This now appears to have been achieved and unless there is a major recovery in USD sentiment in the next couple of days a move to 0.8200-50 could quickly follow.

Yesterday’s UK Budget was a typical ‘smoke and mirrors’ affair, full of Brownesque trickery. His speech was happy to highlight the headline grabbing tax give-aways, while most of the clawbacks were left to the small print of the Red Book. The basic rate of income tax is cut to 20% from 22%, but the 10% starting band is eliminated. There is a big rise in the threshold at which earners pay the 40% higher rate of income tax, but an even bigger increase in the National Insurance bracket (the other income tax). Corporate tax is cut to 28% from 30%, but a number of capital allowances are eliminated and the corporate tax rate for small businesses actually goes up to 22% from 19%.

The implications for GBP were neutral, although GBP did advance for a while this morning following the release of stronger than expected retail sales numbers. February sales were up 1.4% m/m compared to expectations of +0.6% and a revised -1.5% drop for January (originally -1.8%). However, with such large swings in the data it is difficult to draw conclusions either way about the underlying trend, so the implications for policy are not major. Also note that yesterday’s MPC minutes were negative for GBP, with the comments about a reduction in wage growth risk more than offsetting Tuesday’s stronger than expected CPI data. Resistance on cable is at 1.9730-50 (early Feb highs).

In South Africa, the Q4 current account data widened sharply to a seasonally adjusted ZAR143bn (7.8% of GDP) from ZAR99.9bn in Q3, although with the USD weaker and global markets stabilising the ZAR recovered from an initial markdown. Near-term downside risk will remain on USD-ZAR while it stays below 7.30.

Day Ahead
UK – the monthly CBI manufacturing survey is still to come today and the market will be interested in seeing whether the strength of last month is reversed. Last month’s survey saw both orders and output balances reaching their highest levels since 1995.

Data/event EDT Consensus*

GB CBI manu trends survey (Mar) 07.00
US Initial claims (w/e Mar 17) 08.30 323k
US Continuing claims (w/e Mar 10) 08.30 2576k last
US Lead indicators (Feb) m/m 09.00 -0.3%
BE Business confidence (Mar) 09.00 +2.9
US Fed’s Kroszner spks on credit markets 12.30
US Fed’s Kohn spks on asset pricing/credit risk 13.30
JP All-industry index (Jan) m/m 19.50 +0.9%

Latest data Actual Consensus*
US FOMC rate announcement unch unch
JP MoF manu survey (Q1) 0.1 7.1 last
JP MoF all-industry survey (Q1) 6.2 6.4 last
JP Trade balance (Feb, sa) ¥655bn ¥426bn
ZA Current account (Q4) -Z143bn -Z131.3bn
ZA Current account % of GDP (Q4) -7.8% -6.9%
GB Retail sales (Feb) m/m +1.4% +0.6%
EU Manu orders (Jan) m/m -0.2% -1.0%
EU Trade balance (Jan, sa) €1.3bn €2.3bn
* 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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