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April Snow Showers, Chinese FX Whispers

4/5/2006 3:15 am: EUR/$..1.2265 $/JPY..116.78 GBP/$..1.7592 $/CHF..1.2862 AUD/$..0.7235 $/CAD..1.1621

4:00 am E-12 Mar Services PMI (exp 58.2, prev 58.2) 4:30 am UK Mar Manufacturing Production (exp 0.2%, prev 0.2%) 4:30 am UK Feb Industrial Production (exp 0.3%, prev 0.4%) 5:00 am E-12 Feb Retail Trade (exp 0.0%, prev 0.8%) 4/5 09:30 am Fed Chairman Bernanke Speaks. 10:00 US Mar Services ISM (exp 59.0, prev 60.1) 20:45 US Kansas Fed Pres Hoenig Speaks. 9:30 pm AUD Mar Change in Employment (exp10.0K, prev 25.9K) Mar Unemployment Rate (exp 5.2%, prev 5.2%)

A rallying euro and a tumbling dollar continues to be the theme in FX amid prospects that the ECB interest rate hikes have more upside than interest rate hikes by the Federal Reserve. Speculation and indication that Mideast and East Asian central bankers are considering diversifying their FX reserves are also weighing on the world's most popular reserve currency.

All eyes are on whether the Eurozone's services PMI index March would breach its US counterpart (services ISM) as did the Eurozone manufacturing PMI on Monday, and add more fuel on the fired up EURUSD exchange rate. Consensus forecasts see E-12 services PMI at 58.2 vs the US services ISM at 59.0.

Dallas Fed's Fisher made his usual upbeat comments indicating the strong US consumer spending and capital investment would offset any slowdown in the housing sector, while Richmond Fed's Lacker said he expects ongoing solid growth with low and stable inflation. We don't expect this week's Fed remarks to bear any fresh light on the May meeting, but the any remarks next week (after Friday's payroll) may help make a difference. One dollar supportive element is the 75% chance priced in the market for a 5.25% fed funds rate in June. Yet, the greenback remains weighed down by more pressing events.

We recognize the market expectation that the ECB will leave rates unchanged this Thursday and that it would be best for maintaining JC Trichet`s credibility and his solid reputation of establishing market transparency to not raise rates. Yet, aside from the grounds of transparency and consistency, the reasons for a rate hike do not only comprise upside risks to price stability, but also upside risks to escalating liquidity as seen through the 8.0% rise in February M3 growth -- all of which underpinned by the justification of improved sentiment and economic activity (15 yr high IFO, and 5 ½ year manufacturing PMI and rising Eurozone industrial production). Thus, despite market probability of a rate hold this week, we still allow room for an exception, with the question: "why would they wait for next month if the aforementioned reasons warrant a move this week especially as they need to maintain their price stability mandate?" If the Fed is tightening with core PCE price index at 1.8%, then the ECB may as well maintain the 200 bps differential with US rates particularly with CPI at 2.3% y/y.

On a more important level, the market reaction is likely to be neutral to euro positive in the event of no rate hike this Thursday because of the expected escalation in certainty for a May rate hike. It can be argued that the ECB decision to stay on hold this week could weigh on the euro due to jitters ahead of Friday`s release of US March payrolls. But we doubt that a strong payrolls report would have a lasting negative impact on the euro partly because there is the more timely April payrolls report on May 5th, five days before the May FOMC meeting.

This situation could be similar to last month's release of the US February payrolls report, which failed to produce any concrete lasting euro losses that day simply because the FOMC report in the ensuing week was guaranteed to produce a rate hike regardless of the outcome of that particular payrolls report.

As for the Arab Gulf nations' FX reserve story, the expressed intentions of these nations to carry a portion of their reserves into euros should not be neglected simply just because of their small size of reserves relative to China and Japan. The fact that these Gulf nations -- are major producers of the world's most important commodity--which happens to be price in USD--their mere consideration to carry more euros should help the euro against the USD. And when the dollar is dragged in the most highly traded pair in the fx market (EURUSD), that does tend to destabilize the USD, especially when the only major force currently supporting the dollar is optimistic rhetoric by the US central bank, something that needs to be examined with caution since the dollar-positive actions of the Fed i.e. rate hike are near their end.

So how long can one continue to dismiss the Gulf nations' announcements/statements and their psychological impact just because of the small size of nations' fx reserves relative to china and Japan?

First, the China-Japan FX issue should also be examined with caution since Japan's holdings of US Treasuries have stagnated over the past 2 years. These fell 2.4% to $668.3 bln in January, reaching their lowest level since April 2004, largely rebutting the US Treasury's accusations that Japan is keeping its currency artificially low. Thus, it is all too clear that Tokyo is scaling its their large USD exposure but has to do so in a highly gradual manner so as to avoid sending signals of panic treasury selling in the market.

On the Chinese FX front, we continue to expect a meaningful announcement this month. Recall that China revalued last July--2 months before President's Hu Jintao's visit to Washington (Sep 05). Thus, China is likely to make a token gesture around Hu Jintao's Washington visit next week. China's FX move could take the form of widening the USD/CNY band to wider range such as 0.6% from its current daily paltry 0.3%, which still pales in comparison to the 3.0% band vs the euro, yen and other FX.

We expect US Secretary John Snow to resign this month. The deafening silence of the US Treasury chief in the midst of the US-China fx talk of the past 4 weeks -- is unusual. Treasury Undersecretary Tim Adams has been doing most of the talking. We think Snow could step down after this month's G7 meeting in DC, which will then start media speculation as to whether his successor would be dollar positive or negative, and such speculation is in and of itself negative for the US currency.

The chart below shows the weekly US dollar index to be testing major support levels; 1) 7-month trend line support at 88.70 (ascending light blue line); 2) 61.8% retracement of the 80.20-92.79 upmove at 87.98; and 3) the 16-month trend line support (longer ascending blue line) at 87.50,coinciding with the 100-week average.

Momentum indicators such as the MACD point to further gains in the pair with 1.2340 acting as the 38% retracement of the 1.3472-1.1630 decline. Support starts at 1.2270, followed by 1.2220.


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