The market expects the ISM to have risen marginally to 50 from 49.5 previously. The various regional surveys point in different directions. The NY Fed survey and the Chicago PMI showed quite good readings, but the Philly Fed and Richmond surveys
printed a picture of very weak activity in those regions. We suspect the Chicago PMI benefited from extreme clement seasonal (which are much less a factor for the ISM) and so are not impressed by the gains the survey showed in December. Therefore,
we put ourselves on the bearish side of consensus. If the ISM remains below 50, it would be the second consecutive month activity contracted in the manufacturing sector and should support Treasuries.

Car sales should have recovered somewhat from the depressed levels of recently and construction spending should be down again. The ADP employment report might be influential if it deviates from consensus (120 000). The ADP report and the manufacturing ISM will give us some clues about the outcome of the December payrolls, to be released on Friday. For now, we know that December was dryer and warmer than usual which might be a positive, but some other factors (retail sales/construction) might have offset those, leaving us with a provisional payrolls estimate of about 100 000. A full preview of the payrolls will be made public on Thursday and the results of the ADP report might still alter our expectations.

Regarding trading, the new trading year 2007 only starts in earnest today. During the second half of December, Treasuries lost their bullish spin as quite some heavy losses were registered, be it in very quiet and thin end-of-year trading, maybe inspired
by profit-taking following a six month rally. This affected the technical picture that lost its bullish nature. The losses may have been somewhat overdone and therefore if data come out a bit on the softer side of expectations some of the losses may be recouped. In this respect, the market currently discounts only slightly more than a 50% chance of a Fed rate cut towards mid 2007.

So there is again some upside potential (prices) for Treasuries on the condition data come in weakish. So we start the year with a moderately positive view on Treasuries, as long as the bullish technical picture has not been restored, we remain very cautious and look for the price action to convince us that our view may become the majority one. Should the correction higher in yields continues, the 10-year yield should encounter stiff support at 4.84% (Oct. top, cf. graph), where a reaction is expected.
A drop below 4.63% (MTMA) would be a first signal the technical picture is improving.

Source: KBC Bank

The latest release of minutes from the Federal Open Market Committee meeting (FOMC) revealed that Fed officials are uncertain about the future interest rate direction and are concerned about short term inflation.

Forex Investors reacted to the release of minutes from the FOMC by continuing to reduce their USD holdings, this saw the Euro rise to a high of 1.2650 USD overnight from 1.2590.

The minutes were consistent with the Fed chairman’s Ben Bernanke’s testimony to Congress over the past two days in which he suggested that a pause in rate hikes would be a possibility if economic data continues to point towards slower growth.

Forex Investors holding USD also found little comfort in the recent Philadelphia Federal survey for July which fell to 6.0 index points, well below market expectations of 12.0 index points.

In upcoming events for next couple of weeks, the Federal Beige Book summary of economic conditions will be closely watched as will the next durable goods orders data and the next release of gross domestic product (GDP).

The forward-looking part of the statement seemed a bit more balanced between growth and inflation than previously. It noted that, “although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain”. We are a little baffled by this more balanced signal in light of the Fed’s hawkish inflation campaign in recent weeks.

While the phrasing was more balanced, the statement kept a door open to further tightening by saying that, “The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information”. Importantly, this sentence explicitly links the near-term path of monetary policy to both inflation and economic growth, adding more balance to the statement.

Even though the current statement offers less guidance that previously, we still foresee a further 25bp rate hike in August, taking the fed funds rate to 5.50%, as we do not envisage any significant easing of inflationary pressures in the next couple of months. Beyond August we expect the pace of tightening to slow, as the pace of economic expansion will moderate in Q2/Q3 and the industrial cycle is set to soften in the summer and autumn. Further, the Fed is likely to be more cautious going forward, as it will be aware of the lagged impacts of the tightening carried out so far. However, as we expect inflationary pressures to keep building during the second half of this year and growth to pick-up again around year-end, we would pencil in a further hike to 5.75% in December or January. We see the fed funds rate eventually reaching 6% by Q2 2007.

SOURCE: Danske Bank