US Dollar, Japanese Yen Mixed Ahead of US Non-Farm Payrolls, Outlook Remains Dicey

The Japanese yen ended the day sharply lower as a rise in risk appetite lifted carry trades and equities, with the DJIA up 1.34 percent at 8,063.07. The US dollar, on the other hand, was far more mixed as the currency fell against the New Zealand dollar, Australian dollar, and British pound but gained against the euro, Swiss franc, and Japanese yen. Indeed, days like these provide great opportunities to see what sort of interest rate expectations the forex markets holds. The pick up in risk appetite will itself be at risk on Friday, and based on both a Bloomberg News poll of economists and a variety of leading indicators, the release of US non-farm payrolls (NFPs) is likely to show job losses for the thirteenth straight month in January.

At the time of writing, Bloomberg News was calling for NFPs to plunge by 540,000, leaving 2009 to start as 2008 left off: negative. However, based on leading indicators like Challenger job cuts and the ISM employment indices, we think there’s potential for payrolls to fall by 450,000 - 550,000 in January. The steady accumulation of job losses does not bode well for economic growth going forward, as falling incomes will only contribute to further contractions in personal spending. Since the start of the US recession in December 2007, per the National Bureau of Economic Research (NBER), the unemployment rate has climbed from 4.9 percent up to 7.2 percent in December 2008 while personal consumption has slowed from 1 percent in Q4 2007 down to -3.5 percent in Q4 2008. The reaction of the US dollar and Japanese yen could be very formulaic, as risk trends remain one of the primary drivers of price action in the forex markets. If we see that NFPs fall more than expected and the unemployment rate climbs above 7.5 percent, the news could trigger losses in risky assets like stocks, trigger flight-to-safety, and thus, boost the US dollar and Japanese yen. On the flip side, if job losses and the unemployment rate don’t climb quite as much as anticipated, the news could spark enough optimism to boost demand for stocks and forex carry trades, and subsequently lead the dollar and yen lower.

Euro: European Central Bank Unlikely to Cut Rates, but Watch Trichet’s Comments

The European Central Bank said this morning at 7:45 ET that they would leave rates unchanged at 2.00 percent, as expected. As usual, though, it was ECB President Jean-Claude Trichet's subsequent news conference at 8:30 ET that drove price action for the euro. Mr. Trichet's comments initially came across as being very dovish, as he noted that the Euro-zone economy was in a period of downturn, and that economic weakness would persist in coming quarters. On the inflation front, he maintained confidence that the ECB would keep mid-term inflation close to 2 percent, but overall, the level of uncertainty was exceptionally high and the risks to growth were "clearly on the downside." In terms of interest rate expectations, Mr. Trichet left the door open for a rate cut during their March 5 meeting, when the ECB will publish new inflation and growth outlooks. However, he essentially wrote off the possibility of cutting rates to zero, noting that such a level was "not appropriate" as there are a number of drawbacks that come with bringing rates to such low levels. In light of the Bank of England's more neutral stance on monetary policy following their rate cut to 1 percent, there is increased potential for EUR/GBP declines in the near-term, which could skew EUR/USD price action.

British Pound Rallies as BOE Suggests They May Be Done Cutting Rates

The Bank of England pulled no surprises when they cut the Bank Rate by 50 basis points to a record low of 1.00 percent this morning, as the UK economy grapples with a recession characterized by declines in consumption and by businesses “running down inventories, cutting production, scaling back investment plans and shedding labor.” So why did the British pound rally after the announcement? There were indications in the Monetary Policy Committee’s policy statement that the BOE has reached the end of their rate cutting cycle. Indeed, the Committee’s note that the past reductions to the Bank Rate “would in due course…have a significant impact” and mentions that these efforts along with recent fiscal policy measures would “provide a considerable stimulus to activity as the year progressed” sounded very conclusive. With other central banks like the European Central Bank leaving the door open to lower interest rates, the British pound is likely to continue trading in a volatile manner similar to other forex carry trade. Looking ahead to Friday, output in the UK industrial sector is forecasted to have contracted for the tenth straight month during December, which could push the annual rate down to a nearly 28 year low of -7.8 percent. The bulk of the decline should be the result of weak manufacturing growth, as the global economic slowdown weighs on export demand. A decline in line with expectations would add to evidence that the UK trade deficit is widening rapidly, and will also highlight the extent of the recession plaguing the region. As a result, there is potential for brief pullbacks in the British pound early on Friday morning.

Commodity Dollars Hold Up on Surge in Risk Appetite, Canadian Dollar May Come Under Pressure on Friday

The Australian dollar, New Zealand dollar, and Canadian dollar all held up well on Thursday as a jump in risk appetite lifted the currencies against the US dollar. The Loonie was the weakest of the bunch, as the Ivey Purchasing Managers’ Index showed that business activity in Canada slowed for the third consecutive month through January. The indicator unexpectedly fell to a reading of 36.1, indicating that more managers reported a drop in spending for things like equipment, raw materials and labor than those indicating an increase. This report is just another piece of evidence that the economy has entered its own recession, as some market participants had initially believed it would weather the global slump and financial crunch, and data due to be released on Friday at 7:00 ET could exacerbate this sentiment. The Canadian net employment change is forecasted to fall by 40,000 for the month of January while the unemployment rate is anticipated to have risen to a three and a half year high of 6.8 percent from 6.6 percent. Since the employment change tends to be a very volatile release, this should have the greater impact on the Canadian dollar, with a sharper than expected drop likely to weigh on the currency and an unexpected positive result likely to push it higher.

Terri Belkas is a Currency Strategist at FXCM.