Cyclical recovery with USD on the back foot

This week markets will be digesting comments from a large number of US Federal Reserve speakers.

On Tuesday, Chairman Greenspan speaks on the economy, followed by a Santomero speech on Monetary Policy. San Francisco Fed President Parry also speaks on the economy tomorrow. This gives the opportunity for hinting towards a change in the message with regards to the Fed's outlook on inflation and growth.

Currently, the Fed has a neutral bias on growth, in spite of the 7.3% annualised growth seen in Q3 2003 and an easing bias with regards to inflation.

This can be seen in the following quote from the October FOMC policy announcement: "the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming
undesirably low remains the predominant concern for the foreseeable future."

FOMC voter Poole last week said that the FOMC may have room tokeep interest rates low "well beyond March". This has led to markets paring back expectations for the first Fed interest rate hike to nearer to June 2004 from previously pricing in March.

Further volatility in interest rate expectations could well be coming this week. So far this has favoured bonds over equities and the EUR over the USD. The EUR is also currently in favour against the JPY.

In spite of the better than expected Japanese Q3 GDP released last week the NIKKEI is now 13% down from its 2003 highs. JGBs are back on the rise, and EUR/JPY has seen a significant recovery, rising 3.3% since last Monday.

The EUR is also gaining favour over the USD from yield differentials. The spread between 10 year German bunds over US Treasuries has risen back in favour of the bund by around 15 bps.

Many times in the last 18 months, the widening of this differential has been associated with a rally in the EUR. This is line with our longer term view of a rise to 1.20 by end 2003, and further rises in 2004.

In terms of data releases due this week from the US, the two main highlights will be the Empire State manufacturing PMI due out later today and consumer price inflation, out on Tuesday.

It is very normal for inflation to lag the cyclical US recovery, and this time round there should be no exception. We expect CPI inflation to rise 0.1% m/m and 2.1% y/y in October.

High oil prices are not having so much impact, and the Fed has made clear many times that it sees more of an impact on growth rather than inflation from higher oil prices. As the US continues to weaken, and the recovery gathers steam, expect inflation to rise in 2004.

Elsewhere in the major economies, UK retail sales, released on Thursday will attract attention following statements from the Bank of England that it does expect some slowing in personal consumption as debt levels are a concern.

We expect sales for October to fall 0.2% m/m, up 2.0% y/y as the summer spending spree unwinds. Also of interest this week in the UK is the Testimony by Bank of England Governor Mervyn King on Thursday to a Parliament Committee on the
Inflation Report.

The markets will be watching out for hints on whether the latest interest rate hike by the MPC is the first of many or just a reversal of the insurance cut in July.