US Dollar
With the US non-farm payrolls report now behind us, the only thing that traders have on their minds is Tuesday’s Federal Reserve rate decision.  Even though Fed fund futures are predicting only a 20 percent chance that the Federal Reserve will raise interest rates, there are many traders and analysts that are still holding out for the microscopic chance that the Fed will actually raise rates.  Their primary argument is that the Fed will want to ward off inflationary pressures now rather than later, when the economy has slowed and may not be able to bear another dose of monetary tightening. Their concern was validated by a firmer rise in average hourly earnings.  However, most of the economic data that we have seen as of late suggests slower growth in the US economy and at this point, Bernanke may not want to risk a recession along with his credibility by being too aggressive with interest rates.  In terms of payrolls, US companies only added 113k jobs last month, which was 30k less than forecast.  More jobs were lost in the manufacturing sector while the unemployment rate increased from 4.6 percent to 4.8 percent.  The big problem is that the outlook for the labor market is even more dismal.  As US consumers restrain spending and jobless claims begin to tick higher, corporate employers may feel even more reluctant to increase staffing before demand catches up.  The Fed now has the excuse it needs to pause and traders expect them to.  However, even in the off chance that the Federal Reserve does raise interest rates, it may not necessarily be bullish for the US dollar.  The Fed would simply be delaying the inevitable and be blamed for putting the economy at a deeper risk for a sharp contraction in growth.  In addition to the rate decision on Tuesday, traders should also keep a close eye on the statement.  In the most likely scenario, the Fed could pause, but remain relatively hawkish in their statement by suggesting that if inflation pressures do pick up, they are prepared to resume their tightening cycle.  Alternatively, they could raise rates now and then neutralize the tone of the FOMC statement.  As you can see, there are many possibilities, but in the very end, the Fed is bound to pause, but in the meantime, it all hinges on oil and its impact on inflation. 

Euro
Euro bulls have been waiting for a weak US number before pushing the EUR/USD higher and that was exactly what unfolded today.  As soon as non-farm payrolls printed, the EUR/USD rallied 75 pips and a half hour later, the rally extended even further.  The disappointing US number makes a pause from the Fed even more likely and highlights the stark contrast between the future monetary policies of the European Central Bank and the Federal Reserve.  It was only yesterday that the ECB raised interest rates and talked of more to come.  As for the Fed, we are looking for them to put an end to their 2 year long tightening cycle.   Even though the ECB may not opt to raise rates again in late August, they have already alerted the market on their plans to do so later this year.   If the Fed pauses next week, the ECB will have much more leeway to tighten rates every few months rather than consecutively.   The World Cup is now over and economic data has been deteriorating.  Yesterday, we saw a sharp deterioration in Germany’s service sector PMI survey and today factory orders fell 0.5 percent compared to an expectation for a 1.3 percent rise.  This brought the annualized paced of growth from a downwardly revised 16.5 percent to a mere 0.8 percent.   Although the numbers were pretty horrid, it seems that it may be more of an adjustment after strong numbers the month before.   Yet, it would not be surprising to see continually weaker data as it remains difficult for the region’s economy to live up to the euphoria that we saw going into the World Cup. 

British Pound
The British pound screamed higher today as it easily broke above the 1.90 level to hit a high of 1.9129 before retracing.  Yesterday we had 1.90 as our target in our weekly Speculative Sentiment (SSI) report and today, the ratio has grown even more net short to an extreme level of -4.  This suggests that we could see further gains in the GBP/USD before it has any chances of topping out.  The SSI is a contrarian index that is most accurate in trending market conditions and the eight consecutive days of gains that we have just seen in the GBP/USD is undoubtedly a strong trend.  The unclear comment from the Bank of England leaves the market guessing about whether they will hike rates again this week.  So traders will be looking for more evidence of the economy improving or inflation increasing to determine the odds for another rate hike.  As long as the economic data continues to surprise to the upside, we have the catalysts for further gains.  Next week, we are expecting a number of important economic releases including industrial production, BRC retail sales, the trade balance report and the Bank of England’s Quarterly Inflation report.  Since inflation was the primary reason for the BoE’s surprise hike, traders should pay particular attention to the central bank’s inflation outlook when Governor King delivers his speech on Wednesday. 

Japanese Yen
The Japanese Yen rallied against the US dollar but lost ground against many of the other majors.  The Yen is still one of the most undervalued currencies in the FX market.  Even though Japan did not release any economic data last night, speculation of further Chinese revaluation continues to keep the Yen relatively bullish.  The Bank of China just published a report that stated their needs to tighten monetary policy again this year by raising interest rates. We have long said that further Yuan strength should translate into further Yen strength and we expect this to remain a theme.  Meanwhile, the Japanese economy is continuing to gradually improve while the central bank looks forward to more rate hikes of their own.  This mix is positive for the yen, but has yet to filter into meaningful strength for the currency and as such, we continue to look for more gains in the yen.

Kathy Lien is the Chief Currency Strategist at FXCM.