US Dollar: Stocks Surge, But Yields Fall, Subprime Problems Not Over Yet
The hope for a strong non-farm payrolls report tomorrow has helped keep equities, carry trades and USD/JPY in positive territory for most of the US trading session. Buying on the close is soon becoming a new trend in the stock market as the Dow surged up 100 points in the last half hour of trading. Even volatility has pared back with the VIX index falling 2 points today. This has helped carry trades, which thrive on a lower volatility environment to rebound, but the lack of a similar rally in bond yields suggests that not everyone believes that the worst is behind us. Like Fed President Poole, Kroszner indicated that the Fed has an “important role to play in responding to and mitigating the impact of financial crises and shocks.” Nominees for the Federal Reserve Klane and Duke both blamed the Fed for not preventing some of the sub-prime problems by acting sooner. Subprime indices continue to fall amidst warnings from Accredited Home lenders that they may not be able to continue operating. The rebound in the stock market does not mean that risk appetite has returned. Instead traders are dying for a piece of good news. Today’s drop in jobless claims brings the four week moving average of claims down to 305.5k from 309k. The last time average claims were this low was back in May and that month, 190k jobs were added to US payrolls. Although we could see a firm number, this same degree of strength is not likely to happen given the fact that retail sales dropped in the month of June, the ADP employment report slipped to a 4 year low, Challenger reported a 15 percent increase in layoffs and the number of both online and paper job ads. At the same time however, payrolls may not be abysmal given the jump in consumer confidence last month. Economists are currently calling for payrolls to increase by 127k, after rising 132k the prior month. Forecasts range from a low of 60k to a high of 178k. For more on whether July Non-Farm Payrolls Will Hurt or Help the Dollar, see our Special Report. A weak number will probably drive a bigger movement in the dollar than a strong number since August will be a tough month for not only the US economy as a whole, but also the labor market. In addition to NFPs, we are also expecting service sector ISM tomorrow.

ECB Signals September Rate Hike
The European Central Bank must be pretty serious about raising interest rates if they decided to hold a surprise press conference on what was originally scheduled to be nothing more than obligatory monetary policy meeting conducted over teleconference. Without giving any clues on how much further they plan on raising interest rates, the whole point of the meeting was for Trichet to say the words “strong vigilance,” which have been code for “expect an interest rate hike next month.” Despite indications of slower growth in the Eurozone, the recent rise in oil prices, emerging capacity constraints and the potential for stronger wages were apparently too much for the ECB to handle. However the initial reaction in the Euro was limited because Trichet refused to say that monetary policy remained accommodative. Although other ECB officials echoed the concern about inflationary pressures, they also talked about the impact that the strong Euro is having on exporters. BMW reported a 4.6 percent drop in earnings in the second quarter despite an 8.6 percent rise in sales. Part of that was because of the higher costs of raw materials, but the company also indicated that currency effects “are having a greater impact on earnings than previously forecast.” The ECB is being cautious, but their continued plans to raise interest rates in the current environment has analysts still calling for 2 rate hikes by the end of the year, one in September and one in December. Meanwhile Swiss manufacturing PMI was stronger than expected last month. Growth in general has been strong, which is why we expect the SNB to remain hawkish.

British Pound Sees Third Day of Solid Gains
Stronger than expected construction sector PMI follows the upside surprise that we saw in manufacturing PMI earlier this week. Overall the UK economy is strong, which is why we also expect service sector PMI to be firm tomorrow as well. The Bank of England kept interest rates unchanged today, which was right in line with expectations. Next week, the central bank will be publishing their Quarterly Inflation Report and like the ECB we expect them to remain concerned about inflationary pressures. Having just raised interest rates last month, we did not expect a back to back rate hike, but at the same time, we do expect rates to be taken to 6 percent by the end of the year as long as conditions remain the same, that is oil prices hold near its current levels and the global economy does not see a major recession.

Canadian, Australian and New Zealand Dollars Register More Gains
The rebound in the stock market and carry trades has helped to take the high yielding Australian, New Zealand and Canadian dollars higher. Oil prices continued to rise, which has helped to contribute to the gains that we saw today in the CAD. Canadian IVEY PMI is due for release tomorrow. The market is looking for the index to decline sharply from 67.4 to 56.0 in the month of July. However given the recent jump in retail sales and overall resilience of the Canadian economy, we do not expect the drop to be that significant. In fact, PMI could still hold the 60 level. Australia on the other hand will reporting service sector PMI, we are looking for a stronger number.

Yen Crosses Move in Lockstep with Dow
The Yen crosses are up across the board today as they continue to move tick by tick with the Dow Jones Industrial Average. There was no meaningful Japanese economic data released last night and there will be none for the remainder of the week which means that the ebb and tides of carry trades will continue to be determined by the market’s overall appetite for risk. According to unnamed source at the Ministry of Finance, the government is not too concerned about the recent movements in carry trades or the impact of the US subprime problems.

Kathy Lien is the Chief Currency Strategist at FXCM.