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Bernanke's Speech Will Also be Key
In addition to this week's ISM surveys and Friday's labor report, Tuesday's speech by Fed Chairman Bernanke should be instrumental in adding further certainty to the market's probability of 2008 Fed policy. The importance of Bernanke's speech lies in the fact that his views on the economic outlook have not been revealed since his last Congressional testimony in April 2-3. Since then, most FOMC officials have stepped up their anti-inflation rhetoric, with the more hawkish ones (Kohn, Fisher and Kroszner) implicitly dismissing the case for further rate cuts. Nontheless, the Fed's latest central tendency forecasts issued downward revisions on growth and upward revisions on unemployment. How will Bernanke balance these forces with rising inflation risks wil be the key. We expect Bernanke to sound off a firmer tone on inflation and acknowledge the relative stability in financial markets, rather than discuss any improvement on the macroeconomic front. Said differently, the speech is will more likely to eliminate market expectations for a rate cut this summer, rather than add to existing expectations of a rate hike by year-end.

Today's release of the May manufacturing ISM and Wednesday's release of services ISM will also be key in further gauging the extent of the recession in manufacturing and the slowdown in services as well as the employment outlook in the sectors.

May non-farm payrolls are expected to show a loss of 50K jobs in May from a loss of 20K in May, with the unemployment rate edging up to 5.1% from 5.0%. We expect prolonged losses in payrolls into the rest of the year to dampen consumer spending and force the Fed into renewed easing in Q3 once equity markets are pressured by the economic fundamentals.

Euro Struggles Despite IMF Upward Revision
Euro treads lower despite Eurozone factory PMI edged up to 50.6 in May from earlier estimates of 50.5. The figure, however, is lower than April's 50.7. The IMF revised its 2008 Eurozone growth forecast to 1.75% from initial estimates of 1.4%, but expects growth slowing to 1.25% in 2009. The Fund said inflation is uncomfortably high and expects it to remain above 3% in the near future, well above the ECB's mandated ceiling of near 2.0%. It also deemed current ECB rates as “appropriate” and to remain steady for the rest of the year. Last week's latest evidence of further rise in Eurozone inflation means that ECB president Trichet will preserve his hawkish stance in Thursday's press conference. Tomorrow's speech by Bernanke should also help determine whether the euro could recover above the $1.56 figure.

Separately, remarks from the special economic adviser to the ruler of Qatar indicating the need for action on currency policy in order to tackle surging inflation are among the recent factors raising the probability of a revaluation of Gulf currencies. The recognition of rising inflation by the Fed and the US Treasury attests to the prolonging of general inflationary pressures, thereby most likely prompting GCC countries into action on the forex front. The political factors preventing a depegging from the dollar are considerable, thus leaving revaluation as the only option. Any signs of revaluation are likely to have a negative USD reaction to the benefit of the euro.

Resistance is expected to prevail above the $1.56 figure, while downside is seen testing 1.5480 and 1.5440. We expect the euro to remain largely on the defensive ahead of Friday's US payrolls.

Sterling Shows Why It Remains Undesired
Sterling continues to demonstrate why our bearishness in the currency remains unfazed despite gains of the past 2 weeks. The currency lost 2 cents in a few hours, reversing all the advances made in more than one week after UK mortgage approvals hit a record low of 58K in April (versus expectations of 65K and previous 63K) and total lending dropped to a 6-year low.

Separately, UK manufacturing PMI fell to 50.0 in May from 50.8, undershooting forecasts of 50.5. The figure was the lowest since July 2005. The theme of slowing business activity and rising inflation is further resounding inside the central bank. The output price index rose to 62.0 from 61.9, attaining an uninterrupted streak of 34-consecutive monthly increases.

The deteriorating data picture in the UK supports our forecast for interest rates to reach 4.25% by year-end from their currency 5.00% despite deteriorating inflation. We expect the combination of prolonged credit crunch and a weak UK consumer to shift the priority to economic growth away from the Bank of England's government imposed inflation target.

Cable support is seen holding at $1.9580, a breach of which is likely under a stronger than expected ISM reading (above 49). Upside seen capped at previous support of 1.9660.