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Forex - Dollar Rallies as Strong ADP Prompts Banks to Revise Up their NFP Forecast

FXCM DailyFX Fundamentals 07-05-06

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

• Dollar Rallies as Strong ADP Prompts Banks to Revise Up their NFP Forecast
• ECB Needs to be Very Hawkish to Offset Pre-NFP Dollar Bullishness
• New Record High in Oil Prices Sends Yen Tumbling

US Dollar

Traders returning from the long weekend holiday have had to assess the
ramifications of a lot of news this morning. The most significant of which was the North Korean missile launches and the release of the ADP employment survey. The market has taken the failed launch of North Korea’s long-range missile as dollar positive. After strong threats of nuclear war by North Korea last week, the failure of the missile 42 seconds after flight suggests that even if they wanted to, they do not have the capability to follow through with their threats. Therefore at least for the time being, there are no immediate worries about North Korea. This will allow us to turn our full focus onto Friday’s non-farm payrolls report. This morning, we saw the release of the ADP/ Macroeconomic Advisers National Employment Report. Probably the single strongest argument for solid job growth in the month of June, the ADP survey predicted that non-farm payrolls rose by 368k last month. This is also the survey’s highest reading in its five year history. Even though the ADP survey over-forecasted payrolls last month by 47k and the month prior by 55k, the index actually has a slightly higher probability of underestimating payrolls. On average, the standard error of the report on overestimation is 52k versus an average underestimation of 73k. Therefore even if they are overestimating again this time around, that still puts the possible NFP release above 300k. In fact, the ADP report has prompted a number of banks to revise their NFP forecasts upwards. One reputable bank that will remain unnamed actually revised their forecast from 100k to a whopping 200k after the report. Meanwhile also helping the dollar was the stronger factory orders which rose 0.7 percent in the month of May after falling a downwardly revised 2.0 percent the month prior. This is quite encouraging after the weak ISM manufacturing report that was released on Monday. Tomorrow we have service sector ISM, but that will probably only have a minimal impact on the dollar as the market pays more attention to the earlier ECB interest rate decision and the upcoming US non-farm payroll release. What could have more of an impact on the markets is the new high in oil prices of $75.40 a barrel. If prices continue to climb, the worry would be that the strain on the economy is increasing while at the same time inflationary pressures are rising.

Euro

Tomorrow the European Central Bank will be meeting to decide on interest rates and even though they are not expected to make any changes, there will be a lot of attention paid to the meeting and the accompanying press conference. The comments from ECB President Trichet could very well set the tone in the Euro for weeks to come. The market is primarily looking for hawkish comments signaling that there could be at least two more rate hikes in the pipeline from the central banker. The latest correction in the Euro could make it a bit easier for him to say that they need to remain “vigilant” with tackling inflation pressures. If the Euro was trading at 1.28 and above, he may have been afraid of pushing the pair above their suspected comfort zone of 1.30. A late August interest rate hike has pretty much been priced into the market which means that in order for the Euro to resume its rally, we would need to hear Trichet hint at either the possibility of a half point move or a series of follow-up moves after the August one. Meanwhile economic data released this morning was mixed with Eurozone retail sales falling, but service sector PMI increasing strongly. The retail sales report was for the month of May however, which was prior to the beginning of the World Cup. Therefore the stronger PMI index for the month of June is a better reflection of how well the region is doing. The index showed the strongest pace of expansion in six years, led primarily by a jump in German confidence. There is no coincidence between the rebound in the index and the World Cup, which means that this strength could continue into the month of July.

British Pound

A drop in the UK service sector PMI index has kept the British pound under pressure. Service sector activity, though still in expansionary mode fell from 59.2 to 58.7. However the components were not as weak as the employment sub-index increased to the highest level in almost 8 years. In addition, the shop price index fell by the smallest amount in eight months, indicating that the inflationary condition may be improving. According to a wage growth survey, salaries are also increasing, which should help the overall employment outlook. Even though this is encouraging, it should mean little for tomorrow’s Bank of England interest rate decision. The BoE is expected to leave rates on hold and when they do so, they do not make any comments of what they will do in the futures. In these situations, the minutes for the meeting become more important than the meeting itself. Therefore, tomorrow’s rate decision should be a non-event.

Japanese Yen

There has been quite a bit of volatility in the Japanese Yen over the past 24 hours. Initially when news hit the wires that North Korea had launched their missiles, the Yen sold off significantly. However once traders realized that the missile launches were not successful, they bid the Yen back up. When US traders joined the market, they took the Yen back down again as oil prices began to climb. Japan imports nearly all of their oil needs which means that the new high in oil prices at a time when the Yen has weakened significantly against the dollar could be damaging to the economy. The only hope is that as tensions remain high in Japan, increased defense mechanisms would mean increased military spending which could be just the additional dose of stimulus that the economy needs to pave the way for stronger growth and the removal of the country’s zero interest rate policy. There are now rumors that the BoJ could raise interest rates by a quarter of a point rate hike as early as next week. Although this is still a low possibility amidst the Fukui scandal, it certainly signals how close we are to an eventual interest rate hike.

 

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