NEWS / Central Banks

Forex - Dollar Sells Off as ISM Signals Possible Weakness in Payrolls

DailyFX Fundamentals 10-02-06

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

??? Dollar Sells Off as ISM Signals Possible Weakness in Payrolls
??? British Pound Rallies After a Basket of Good Data
??? Risks Weighted to Downside for USD/JPY

US Dollar

The market can not seem to shake off its range trading mode as we head into the new week. Dollar strength stopped short of key levels against the Euro, Japanese Yen and British pound on Friday and has since relinquished a portion of its losses. With currency volatilities still near record lows, the hope is that Friday??™s non-farm payrolls report will release us from the pain of an extremely dull start to the third quarter. Many analysts have been talking about the risk of a major break in the currency market, but none can commit to a clear timing. Unfortunately, with most major central banks holding monetary policy steady and global inflationary pressures subsiding, the outlook for interest rates and economic growth has become very predictable. What the market needs is a major unexpected surprise and when volatility contracts to an extreme point, we typically do get one, but from the left field. The last time volatility was extremely low and we saw a very tight range in most of the majors was between late January and mid April. The catalyst for the ???breakdown??? in the US dollar back then was a surprisingly dovish FOMC statement that suggested the end of rate hikes would be near. This time, with the odds stacked far higher in favor of a rate cut versus a rate hike as the Fed??™s next likely policy move, we will need to see sharply weaker job growth, in the mid double digits to tip the dollar over. On the flip side, a dollar rally could come from either another shock to oil that could resurrect inflation concerns or more realistically, more neutral comments from the ECB after their expected rate hike on Thursday. Looking ahead to Friday??™s release, the leading indicators for payrolls that we have seen thus far, namely Friday??™s help wanted index and Chicago PMI report along with today??™s national ISM report suggests that job growth in September should be weaker than job growth in August. The employment component of the ISM report dipped back into contractionary territory and even though it has more of a direct impact on manufacturing payrolls, it is worrisome nonetheless. Furthermore, not only did that component dip, but the prices paid index also dropped significantly, which triggered the sell-off in the US dollar. Although pending home sales and construction spending were stronger than expected, the dollar shrugged off the good news and focused on the bad.

Euro

Firmer September manufacturing PMI reports from the Eurozone has helped to push the Euro higher after it hit a range low against the US dollar on Friday. The stability of the European industrial sector should be extremely encouraging for the European Central Bank ahead of their interest rate decision on Thursday. Nine out of the eleven components of the report saw an acceleration including the employment and price indices. The ECB is expected to raise rates by 25bp to 3.25 percent, narrowing the spread between US and Eurozone interest rates from 2.25 percent to 2 percent. The interest rate hike itself has been long priced into the market after hawkish comments from the ECB President. The key will not be what they deliver now but what they will deliver later, if anything at all. With global inflationary pressures subsiding and last Friday??™s CPI estimate forecasting a dip back below target for the annualized rate, the ECB may feel less pressed to keep on raising interest rates as aggressively as they have previously signaled. If the ECB decides to join the Fed on the sidelines, it could force the EUR/USD currency pair to break its recent range lows.

British Pound

The British pound has finally bounced after six consecutive days of weakness against the US dollar and it could not have been a better fusion of technicals with fundamentals. The sell-off in the pound stopped right at the 100-day SMA thanks to a stronger than expected manufacturing PMI report and a faster rise in house prices. Stabilization in the housing market is something that we have seen evidence of often in the UK, even if the rise in house prices was the fastest in 2 years, but an acceleration in manufacturing activity was a welcome surprise. The Bank of England will be meeting to decide on interest rates on Thursday. They are not expected to increase interest rates after the surprise hike in August. Merger and acquisition news also contributed to today??™s rise as water utility company AWG PLC is up for grabs by foreign funds.

Japanese Yen

The stronger Tankan report has helped the Japanese Yen rally against the US dollar, but the rise was weak at best as the Bank of Japan??™s decision to lower its CPI forecasts for fiscal years 2006 and 2007 offset some of the optimism. The question of the moment is whether last night??™s reports suggest that the Bank of Japan will move faster on raising interest rates. The problem is that even though business sentiment has improved, primarily due to the recent weakness of the Japanese Yen, the improvement has yet to filter to the consumer level. Labor cash earnings were exceptionally weak which is a cause for concern. However, we do want to point out that the average rate assumed by Japanese companies for the second half of the year is 111.31. This means that they too think the Yen is undervalued against the dollar. It is becoming increasingly dangerous to be short USD/JPY near its five month highs. Aside from the benefit of carry or the interest rate yield, the risks are weighted far more to the downside for USD/JPY than up.