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Saturday February 2, 2008 - 01:54:20 GMT

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Forex Research - Why Did the Dollar Rally on Negative Non-Farm Payrolls?

Friday, 01 February 2008 22:45:17 GMT

Written by Kathy Lien, Chief Strategist

• Euro: Unable to Break 1.49
• British Pound Falls Ahead of Next Week’s Bank of England Rate Decision

Why Did the Dollar Rally on Negative Non-Farm Payrolls?
Earlier this week, the Federal Reserve told the markets that the reason why they lowered interest rates by 50bp to 3 percent was because the labor market is weak. However, the severity of the problems with job growth was not clear until the release of this morning’s non-farm payrolls report. In the month of January, non-farm payrolls fell for the first time in 4 years. The 17k jobs that were lost, makes it difficult to argue that the US economy is not already in a recession and as a result, the Federal Reserve will need to continue to lower interest rates. Unless there is a strong rebound in job growth during the month of February, it is realistic to expect a back to back half point rate cut. Given the weakness of the non-farm payrolls numbers and the implications for where interest rates are headed next month, the US dollar should have sold off, but it didn’t. There are a number of reasons to explain this bizarre price action. First, another 50bp was already priced into the futures market and even though there was a knee jerk reaction across the financial markets, traders quickly realized that nothing has changed. Bond yields are only off slightly and rate cut expectations remain the same. We also have over 6 weeks before the next interest rate decision and surprisingly strong retail sales, consumer prices or February non-farm payrolls could easily change the Fed’s outlook on interest rates. Also, not all of the news released today was bad news. The unemployment rate declined to 4.9 percent from the psychologically crippling 5 percent level while manufacturing ISM rebounded strongly in the month of January. Prices paid also surged to the highest level in 18 months, reflecting growing inflationary pressures. On top of that the ECB announced that they will no longer be extending their dollar lending facility. According to IFR Markets, there has been speculation that some accounts have been borrowing the cheaper USD facility and using it to fund higher cost positions such as EUR and GBP. When the ECB put an end to that today, these accounts might have bought back dollars to repay their loans. In the week ahead, the US economic calendar is light with only factory orders, service sector ISM and pending home sales due for release. We continue to expect most of these numbers to be dollar negative.

Euro: Unable to Break 1.49
For the EUR/USD, the 1.49 price level seems to be an insurmountable barrier. Eurozone economic data was stronger than expected and US data was weak, but still the Euro failed to close above 1.49. Despite the strength of the currency and the deterioration of US growth, manufacturing activity actually accelerated in Germany, France and Italy during the month of January. Data such as this is the primary reason why the European Central Bank remains stubbornly hawkish. They will be meeting to decide on interest rates again next week and even though rates are expected to be left unchanged for the eighth consecutive month, all traders should keep an eye on the comments made by ECB President Trichet at the accompanying press conference. Will he express any concern about growth or will he focus completely on preventing inflation from having second round effects on the Eurozone economy. Meanwhile Switzerland also reported improvements in manufacturing activity with the Swiss PMI index rising from 61.3 to 61.6. Swiss consumer prices are due for release next week and even though they are expected to drop, it will not alter the Swiss National Bank’s plans to keep interest rates unchanged.

Visit the Euro Currency Room for resources dedicated specifically to the Euro.

British Pound Falls Ahead of Next Week’s Bank of England Rate Decision

The British pound was the worse performing currency today, having fallen over 1 percent against the US dollar and Japanese Yen. The pace of growth in the manufacturing sector slowed in the month of January which is part of the reason why the pound weakened but the other reason is because the Bank of England will be announcing an interest rate decision next week and the market expects them to lower rates by 25bp. Next to the US Federal Reserve, they are expected to be the central bank that lowers interest rates most aggressively. The economy has been on a downward spiral, led by a rapid deterioration in the housing market. In addition to the BoE decision, we are also expecting construction sector PMI, service sector PMI and industrial production. We expect most of these numbers to be pound bearish, taking the currency pair back down to 1.95.

Visit the British Pound Currency Room for resources dedicated specifically to the Euro.

Australia, New Zealand and Canada Look Forward to Busy Data Week

Despite a sharp sell-off in commodity prices, the Australian and New Zealand dollars extended their gains while the Canadian dollar recovered from Thursday’s losses. Economic data was mixed with a contraction in manufacturing activity in Australia offset by a sharp rise in the commodity price index. Canada also reported a jump in industrial product prices but slower growth in raw material prices. The Commodity Currencies will be in play next week with the Reserve Bank of Australia announcing an interest rate decision, New Zealand and Canada reporting employment figures and Canada releasing IVEY PMI. A strong labor market and rising inflationary pressures is expected to push the RBA to raise interest rates to 7 percent. If they raise rates, they would be the last ones standing.

Tell us what you think on the Canadian dollar Forum.

Correlation between Carry Trades and Equities Continue to Breakdown
Throughout this past week, we have talked about how we expect the correlation between carry trades and equities to break. We saw countless examples of this including today when the Dow rallied 92 points and carry trade currencies such as EUR/JPY and GBP/JPY actually weakened. Traders are hesitant to take on risk even though they are buying stocks. Volatility remains high which makes it difficult for carry trades to rally. We expect this trend to continue amidst the lack of market moving numbers out of Japan next week.

Visit the Japanese Yen Currency Room for resources dedicated specifically to the Euro.




By Kathy Lien, Chief Strategist of
Contact Kathy Lien about this article at [email protected]

©2007 DailyFX. All Rights Reserved.


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