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FXCM - Progressive is not Same as Aggressive – Euro Rally Post ECB Limited at Best

FXCM - DAILYFX 08-03-06

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

- US Dollar Traders Cautious as they Await Payrolls - the Last Piece of the Puzzle
- Progressive is not Same as Aggressive – Euro Rally Post ECB Limited at Best
- British Pound Skyrockets as BoE Surprises with Quarter Point Hike

US Dollar

Currency traders are being very cautious with their positioning going into tomorrow’s non-farm payrolls report. The consensus forecasts have been so unreliable over the past few months that whether job growth was strong or weak is really a coin toss at this point. Incoming economic data continues to make the positioning ahead of the release difficult. Jobless claims jumped from a downwardly revised 301k to 325k in the week ending July 29, but at the same time, the employment component of the service sector ISM index increased from 52 to 54.4, suggesting faster job growth. Individual forecasts from the leading bank analysts on Wall Street could not be more different than night and day. Of the 76 analysts surveyed by Bloomberg as of today, the most pessimistic analyst is calling for 76k while the most optimistic is calling for 225k. As for traders rather than analysts, the payrolls derivatives auction settled today at 144,480 jobs compared to 152,700 jobs yesterday. No one is exactly sure which direction the scale is tipped, but because of that, tomorrow should prove to be a volatile day. Payrolls will be the last clue to the puzzle of whether the Federal Reserve will raise interest rates next week and will also provide us with better insight into whether the US economy and its consumers can handle another rate hike. So far, we have not been seeing any massive layoffs, but at the same time, we have also not been seeing any massive hiring. If payrolls come out above 175k, we expect to see the probabilities of a rate hike next week to skyrocket, along with the US dollar. However if payrolls are below 110k, we have a grave problem at hand as Fed rate hike probabilities will likely shrink towards zero. Anywhere between those numbers leaves us at square one – which would be more cautious positioning going into Tuesday’s monetary policy announcement. Either way, the warnings signs are there for a potential slowdown in the US economy. Factory orders grew by a much less than expected 1.2 percent in the month of June while the ISM service sector index slipped from 57 to 54.8. The risk for higher oil prices remain especially as Iran talks up the possibility of $200 a barrel oil if the UN imposes sanctions. It will probably take a lot more to please dollar bulls than bears.

Euro

Even though the European Central bank raised interest rates by 25bp to 3.00 percent today and signaled that more will come, the rally in the Euro was mediocre at best. Traders were disappointed that the word “vigilance” has disappeared from ECB President Trichet’s vocabulary even though he said that rates are still accommodative and a progressive withdrawal of accommodation may be warranted. Unfortunately, progressive does not mean aggressive. Therefore the ECB will probably forgo raising interest rates at the end of August and postpone the next hike until September, unless of course oil prices skyrocket above $80 a barrel in the meantime. The central bank is still worried about inflation and even though they feel that economic growth remains strong, there are risks that could lead to slower growth. We are already seeing some signs of weakness after the glory days of World Cup infused June. Eurozone service sector PMI fell from 60.7 to 57.9 in the month of July, led primarily by a steep drop in the German services index. Unsurprisingly, the employment component of the German index soared going into the World Cup and has fallen significantly post World Cup. Eurozone retail sales also grew at a slower pace, rising by 0.5 percent compared to a forecast of 0.8 percent. However all is not lost with the Euro. Traders are still waiting for the US numbers. If tomorrow’s payrolls report come out poorly and the Federal Reserve pauses next week, we could see a run up to 1.30 because the ECB would be left as the only one of two central banks to still be raising interest rates. If it comes out strongly, we could easily a 75 to 100 point drop in the EUR/USD.

British Pound

The Bank of England came out from the left field to surprise the markets with a rate hike today. Originally expected to sit on their hands for the entire summer, the central bank announced a quarter point rate hike that brought interest rates to 4.75 percent. Frequently credited to be one of the smartest central banks in the world, the Bank of England, with its slimmed down Monetary Policy Committee wanted to prevent against problems in the future by hiking rates now. With inflation expected to remain above their target for some time and economic growth recovering significantly, the central bank delivered its first rate change since August 2005. The British pound skyrocketed on the surprise news, with the gains exacerbated by the Bank of Italy’s decision to switch a quarter of its foreign exchange reserves into British pounds. Since 2004, the BoE has upped its Sterling holdings from zero to 24 percent and dropped its US dollar holdings from 84 to 63 percent. We doubt that this is a trend unique to Italy alone. Many more central banks are diversifying out of the dollar into currencies such as the Euro, British and Japanese Yen. Looking ahead, the Bank of England did not give any clear signal of whether they will raise rates again this year, but traders are pricing in a 40 percent probability of another rate hike.

Japanese Yen

The Japanese Yen weakened against all of the major currency pairs as Hideto Fujii, Japan’s Vice Finance Minister warned against overly aggressive interest rate hikes by the Bank of Japan. He said that the central bank should carefully evaluate the impact of their interest rate hikes on the economy before raising rates again. We are coming up on possible repatriation by Japanese companies ahead of two possibly yen positive flows. A massive US Treasury coupon repayment is due to be made and with the risks of dollar weakness ahead, Japanese investors may be tempted to repatriate a good portion of the payments. At the same time, Japan’s fiscal half year ends in September and we could also see companies repatriate some funds in order to dress up their balance sheets as well.

 

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