The U.S. Institute for Supply Management’s non-manufacturing index improved in April with a reading of 50.7 compared to consensus expectations of a 49.0 level. The index contracted in March for the first time in 14 months.

“Being almost exactly at the dividing line between signalling contraction in services sector activity (less than 50) and expansion mode (above 50) means that the services sector is practically flat in its direction, but this is enough to suggest that the downward movement in the previous month was temporary in nature and related to the Iraq effect,” RBC says.

“By signalling a slight improvement in U.S. non-manufacturing conditions, this morning’s report should reduce even further any remaining talk of a Fed rate cut tomorrow afternoon,” RBC notes. “We are expecting no change in rates, and the tone of the accompanying comments will likely point towards a more balanced set of risks than was the case at last month’s meeting when the Fed was uncharacteristically blunt in stating that the balance of risks was difficult to read at the peak of the conflict in Iraq.”

“With the end to the conflict in Iraq, oil trading around $14 below its intra-day peak in early March, consumer confidence now surprising substantially on the upside, and a better stock market performance recently, the outlook for the U.S. economy has improved markedly and this will likely keep the Fed in a holding pattern on rates for some time yet,” RBC predicts.

“Our forecast is for the overnight rate to remain at 1.25% for the duration of this year before the Fed starts aggressively raising rates next year as excess supply in the U.S. economy gradually dries up and inflationary pressures eventually re-emerge. Our year-end 2004 target for Fed funds is 4.5%.”