Dollar Rallies after NFP - How Much Further Can it Rise?

Non-farm payrolls were right in line with expectations, triggering a broad based dollar rally. Even though the US economy saw a net job loss for the sixth consecutive month, the sheer fact that non-farm payrolls was no where near -100k, was enough to drive the dollar higher (More details on Non-Farm Payrolls). According to the yield curve, traders now expect more aggressive tightening by the Federal Reserve than the ECB over the next 12 months. If inflation continues to trend higher, this is very possible since the Fed has more room to raise interest rates. The ECB’s disappointment and the market’s relief that NFPs were not as bad as they could be should lead to further dollar strength in the coming week. However the underlying weakness in the payrolls report and the sharp drop in service sector ISM indicate that the US economy is still on a downward spiral. Payrolls for the month of June was revised to more negative levels, while the unemployment rate remained unchanged at a 4 year high. With jobless claims topping 400k last week, the labor market will only get worse in the coming months. American Airlines announced today that 7,000 jobs will be cut by the end of 2008 to offset the pain of rising fuel prices. This follows the equally severe layoffs announcements that we have already heard from Starbucks, Citigroup and Goldman Sachs. The service sector is back in contractionary mode with the ISM index falling from 51.7 to 48.2. The employment component of the report fell to a record low, foreshadowing more problems in the labor market. Yet even as economists and analysts, (us included) are calling for doom and gloom, the numbers have yet to show it. Today’s NFP figures are not as bad as the market feared while consumer spending remains positive. Inflationary pressures on the other hand are continuing to rise. Oil prices hit a new record high above $145 a barrel. This will add further pressure to the prices paid component of service sector ISM, which already hit an 11 year high in the month of June. The US economy will worsen, but probably not as quickly as inflationary conditions. The rise in oil prices is testing the patience of the Federal Reserve. If they continue to remain on hold and fail to indicate when they plan on raising interest rates, the rally in the US dollar could be limited.

Euro Collapses as Trichet Proves to be a Big Disappoint

For the first time since 2007, the European Central Bank raised interest rates by 25bp to 4.25 percent. However despite this move, the Euro dropped more than 200 pips when ECB President Trichet failed to signal to the markets that interest rates would be increased again this year. Going into the ECB meeting, the Euro rose to a high of 1.5910, indicating that currency traders were clearly banking on hawkish comments. Instead, Trichet played down the prospect of more rate hikes by saying he has “no bias” more than 5 times in the question and answer session with reporters. For Euro bulls, having no bias is just as bad as not having raised interest rates today. Despite strong retail sales, a sharp drop in the German unemployment rate and much stronger than expected producer prices, the ECB was surprisingly neutral. For a staunch inflation fighter, it is quite uncharacteristic to have no bias especially on a day when oil prices hit a new record high. German factory orders are due for release tomorrow. A strong rebound is expected but that may not have much of an impact on the Euro. We expect a bit more weakness before some stabilization in the EUR/USD.

British Pound: Economic Data Continues to Worsen

The British pound extended its losses as bad news continues to pour out of the UK. Service sector PMI fell to the lowest level since October 2001. This is the first time in 7 years that there has been a contraction in service, manufacturing and construction sector PMI. Back then, GDP growth slowed to 0.1 percent, the lowest level since the second quarter of 1992. These numbers explain why the Bank of England has been so reluctant to raise interest rates. They know that their economy is in bad shape and that the downturn is deepening. We expect the UK labor market to fall into the same downward spiral as the US labor market. Many of the jobs that have been cut in the financial sector have been worldwide and London will feel the same pains as the US.

Australian, New Zealand and Canadian Dollars Hit by US Dollar Strength

Broad dollar strength has pushed the Australian, New Zealand and Canadian dollars lower. The Australian trade deficit was slightly wider than expected as exports slow and imports grow. Like the rest of the world, oil is the primary culprit. With Australia now back to running a trade deficit, second quarter growth remain soft. In the first quarter, the Australian economy actually grew by the slowest pace in 2 years. Interestingly enough, commodity prices were unchanged in the month of June. The annualized pace of growth still remains near record highs. Canada is the only country with any meaningful economic data tomorrow. The IVEY PMI report is due for release. Although a dip is expected, the index should remain near its 11 months highs.

No Blowout Moves in the Japanese Yen

The US dollar was itching for a breakout against the Japanese Yen prior to the non-farm payrolls report. Even though a breakout did occur (from the triangle formation), the rally was modest at best. Resistance is still at 107.20 and with the US markets closed for Independence Day tomorrow and no meaningful data due for release next week, the currency pair will probably remain trapped within its 105 to 108 trading range. It is worth noting that CHF/JPY hit a 17 year high this morning, but the gains were quickly erased after the NFP release.

Kathy Lien is the Chief Currency Strategist at FXCM.