Global Markets Weekly – 16^th October 2006

Key Macro economic developments

• The minutes of the September 20^th meeting of the Federal Reserve’s Open Market Committee (FOMC), released last week, served as a timely reminder that, in the Fed’s eyes at least, it is still far too early to give the ‘all clear’ on the inflationary front. Policymakers again referred to the uncomfortably high level of core inflation, a concern that will be largely unaffected by the recent decline in oil prices, and the ‘substantial risk’ of this trend persisting given the high levels of resource utilisation across the US economy. Indeed, the stream of hawkish comments from Fed officials over the past week would appear to be a concerted attempt to realign market expectations after the possibility of a rate cut during Q1 2007 had begun to be priced into interest rate futures. Given the concern over core inflation, a gradual and orderly shift to a brief period of sub-par growth would still appear to be consistent with the Fed’s overall game plan, and further confirmation of this trend should not necessarily be expected to draw a response from policymakers.
• In the Euro-zone meanwhile, the latest set of industrial production data from the ‘big three’ nations served to highlight the momentum that remains behind the region’s cyclical upturn. Output growth proved to be particularly brisk in Germany, and estimates of regional growth in 2007 are on the upgrade.

Key global market developments

• The US dollar appears to have responded to the shifting sentiment towards the Federal Reserve’s monetary policy outlook in a rather asymmetric manner during recent weeks - holding relatively steady while the financial markets began to discount the possibility of a rate cut early next year, and more recently strengthening (particularly against the euro) as such expectations faded. This rather skewed reaction may be attributable to the earlier failure of the EUR/USD rate to decisively clear resistance levels around the $1.28 mark - frustrating momentum traders - as well as market positioning, given the substantial long-euro speculative position that had developed. There appears to have been a reluctance to add further exposure to the euro even while the US data disappointed, in turn preparing the ground for the dollar’s current rally as interest rate expectations stabilised and the performance of US equities improved.
• Given the ongoing decline in commodity prices/rising trend of equities, and the beneficial impact this appears to be having upon US consumer confidence, the dollar is unlikely to trend significantly lower in the near-term and the long-running spell of range trading will likely persist. But the ability of the dollar to draw a sustained benefit from the Federal Reserve’s more hawkish commentary is (at best) questionable. Indeed, on a longer-term view the data of recent months have hinted at some deterioration in the US economy’s growth/inflation trade-off, a development that would typically be viewed as a significant negative for a currency’s attractiveness amongst investors.
• More immediately, a run of poor data on the inflation front could yet prompt a more rigorous examination of the prospects for further monetary tightening over the coming months. The US Treasury market - even after the recent sell-off - appears ill prepared for such an eventuality. A further spike in yields and therefore mortgage interest rates would clearly threaten the tentative indications of a stabilisation of sentiment towards the US housing market, given the implied decline in housing affordability. Overall, if the financial markets are indeed currently underestimating the true level of inflationary pressures within the US economy - as the Federal Reserve would seemingly believe - the full and more enduring implications for the dollar are far from unambiguously positive.

Indices, Interest rates and Inflation

	Close 13-Oct-06	1 Week%	1 Month%	3 Months%	YTD %
FTSE all share	3153.20	2.50	4.93	7.70	10.75
FTSE 100	6157.31	2.60	4.50	6.80	9.58
S&P 500	1365.62	1.19	3.61	9.93	9.40
Nasdaq Composite	2357.29	2.49	5.82	14.76	6.89
DJ Stoxx (Europe)	377.67	1.69	5.34	12.56	14.82
Nikkei 225	16536.54	0.61	4.99	9.53	2.64
Hang Seng	17988.86	0.48	4.53	10.32	20.92

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