NEWS / Monetary Policy

Forex: Euro to Run the Show Next Week With ECB Meeting

DailyFX Fundamentals 06-02-06

By Kathy Lien, Chief Strategist of www.dailyfx.com

- Euro to Run the Show Next Week With ECB Meeting
- Fed Rate Hike Expectations Pared Significantly After Poor NFP
- Strong Yen Reduces Chances of BoJ Rate Hike

US Dollar

If the G7 meeting can be characterized as the main catalyst for the major sell-off in the US dollar between April and May, then non-farm payrolls will probably go down as the main culprit of the dollar??™s weakness in June. This morning, we learned that job growth in the US economy last month was extremely weak. Falling short of even the most pessimistic analyst??™s expectations, US companies added only 75k jobs last month, compared to an extremely lofty forecast of 170k. However the bigger issue is not just how disappointing the payrolls number was, but its potential impact on the US economy going forward. Consumer confidence tends to have a very strong correlation with non-farm payrolls and given the big downtick in payroll growth last month, it would be surprising if confidence did not fall. Weaker confidence usually means weaker spending as consumers worry about future earnings. Ultimately this means that the Federal Reserve will have to rethink raising interest rates in June. Fed rate hike expectations have now fallen below 50 percent, indicating that over half of the market thinks that the Fed will pause in June. To illustrate how bad the payrolls number was, it was the weakest since October 2005 and according to Barry Ritholtz, less than half of the monthly population growth. In addition, of those people who do have jobs, they are working fewer hours in May and their earnings growth was near flat. The unemployment rate did tick lower from 4.7 percent to 4.6 percent, but it is widely known that the household survey which publishes the unemployment rate tends to have a larger sampling error than the payroll report. No matter which way you slice it, this is a bad number and it is negative for the US dollar. There is no doubt that the US economy is weakening and the Federal Reserve is nearly done with raising interest rates. All the market needs to see from now till the rate decision at the end of the month is the consumer price index on June 14th. Inflation pressures have been their solitary reason for remaining hawkish so if the CPI number shows slower growth, it could slam the door on another rate interest hike. Next week, the economic calendar is relatively light with only the service sector ISM report and the trade balance worth watching. However on Monday afternoon, Federal Reserve Chairman Ben Bernanke, ECB President Trichet and Bank of Japan Muto will all be speaking at a monetary conference in Washington. At this critical juncture in Fed policy, the comments by the three major central bank officials will be particularly important and could potentially cause more volatility for the market in the week ahead.

Euro

The weaker US non-farm payrolls report has helped the Euro rally significantly today but unfortunately the strength of the rally was not large enough for the move to mark a meaningful break of the pair??™s recent consolidation. Prices are stalling at the same highs that the pair topped out at on May 12 and 15. Nonetheless, the move still looks constructive and 1.30 remains the path of least resistance both fundamentally and technically. Stronger inflation numbers this morning continues to fuel the debate of whether the European Central bank will be raising rates by 25 or 50 basis points. Producer prices increased 0.8 percent in April with the pace of growth in March also upwardly revised from 0.4 percent to 0.5 percent. This past week, the market??™s primary focus was on the US, but in the upcoming week, Europe will run the show. The US economic calendar is light while the Eurozone economic calendar in comparison is jam packed with important economic data. Not only are we expecting a key central bank rate decision where the market is divided on the potential outcome, but we are also anticipating retail sales, industrial production, service sector PMI reports and trade figures from many important countries within the Eurozone. The ECB rate decision should not be underestimated because even if the ECB only delivers a quarter point rate hike, if they hint that more is to come, the Euro could continue to rally as the market anticipates continued tightening by the central bank which is positive since it comes at a time when the Federal Reserve is nearing the end of their tightening cycle.

British Pound

Riding on the coattails of broad dollar weakness, the British pound has performed strongly against the US dollar today. However against the Euro it struggled to recuperate earlier losses. The construction sector has been performing well in the Eurozone but in the UK, activity fell from 53.7 to 52.7, which was more than the market initially anticipated. The previous strength in UK economic data is coming more into question which makes next week??™s BRC retail sales, industrial production and trade balance reports even more important. The Bank of England will also be holding a monetary policy meeting next week. They are expected to leave interest rates unchanged at 4.50 percent and when they fail to make any changes, they also do not make any statement. Therefore, it should be a non-event.

Japanese Yen

The Japanese Yen ended the day stronger against the US dollar, but unchanged against most other currencies. The only piece of data released overnight was money supply, which saw the biggest drop since 1971. This confirms the Bank of Japan??™s continual removal of liquidity from the market as a part of their process of ending quantitative easing. There is barely any data on the Japanese economic calendar next week which means that the yen will probably leave its short term fluctuations to the other majors. Deflation still persists, suggesting that any interest rate hikes will not come until the fourth quarter at the earliest. Also, with the yen so strong against the dollar, the BoJ will probably be even more cautious in fear of causing a shock to their export dependent economy.