Will Weak Payrolls and ISM this Force the Fed to Drop their Inflation Bias Next Week?
Bad news begets bad news which begets even more bad news. This is why both the US dollar and the Dow are lower in Friday trading. This morning, we had much weaker than expected non-farm payrolls. Despite a sharp rise in consumer confidence and a drop in average weekly jobless claims, US corporations only added 92k jobs onto their payrolls, which was the weakest level since February 2007 and the third weakest in 2 years. This brought the unemployment rate up to 4.6 percent, the highest since September 2006. The divergence between jobless claims and non-farm payrolls indicates that even though companies are not firing, they are also not hiring. With hedge funds and mortgage lenders blowing up left and right, August could be ugly for the labor market. American Home Financial announced that they will be cutting their staff from 7000 to 750, which is a loss of 6250 jobs. We are sure that they are not the only ones to be downsizing. In addition to American Home Financial’s announcement and the bad non-farm payrolls number, Standard and Poor’s also cut its outlook on Bear Stearns to negative while Wells Fargo raised its mortgage rates on 30 year jumbo loans from 6 7/8 percent to 8 percent. The last piece of US data released today was service sector ISM which dropped from 60.7 to 55.8. The fall in bond yields yesterday was an accurate sign that we have yet to see the worst. Will there be respite next week? Possibly - the economic calendar is very light and the only piece of US data with any market moving potential is the Federal Reserve’s monetary policy decision. Rates are expected to be left unchanged, but as usual, the market will be focusing on the accompanying statement. Will the recent movements in the stock market and endless troubles in the US economy force the central bank to drop their hawkish inflation bias? The potential exists, but based upon the latest Fed rhetoric, they are not ready to do so.

Euro Benefits from Deteriorating US Outlook for US Economy
Yesterday, ECB President Trichet signaled to the markets that despite the recent slowdown in European growth, they still have full intentions of raising interest rates next month. This of course is bullish for the Euro and helped to take the currency higher against the US dollar. However the breakout in the Euro today was more a reflection of the deteriorating conditions in the US economy than the more promising outlook in the Eurozone. We are currently in an environment where the Federal Reserve may have no choice but to slowly downgrade their degree of hawkishness while the ECB is expected to deliver one and possibly even two rate hikes by the end of the year. Although service sector ISM in the Eurozone was stronger than expected in the month of July, but retail sales for the region was weaker. Like the US, the economic calendar is relatively light. German factory orders, industrial production, the trade and current account balances are the only pieces of data that are potentially market moving and even then, they are second tier data. All of these reports reflect aspects of the Eurozone economy that may be affected by the strength of the Euro. Therefore a downside surprise is far more likely than an upside one. Meanwhile, the Swiss franc rallied significantly today despite a drop in consumer prices. With gold prices up sharply, this may reflect flight to safety. Swiss unemployment and the SECO consumer climate reports are due for release next week. Overall, the Swiss economy has been doing very well, which is why we expect both reports to be firm.

British Pound Breaks 2.04, Quarterly Inflation Report Expected Next Week
It has been a strong week for the British pound despite mixed economic data. Even though activity in both the manufacturing and construction sector accelerated in the month of July, service sector activity slowed. All of these indices remain well above it comparative US levels, which is the reason why the currency has outperformed the US dollar. The Bank of England left interest rates unchanged, which made the rate decision a non-event, but next week Central Bank Governor King will be delivering their Quarterly Inflation Report. Based upon the price action in the British pound, traders expect the central bank to remain hawkish and signal the possibility of another rate hike this year. Although this is the most likely scenario, when it comes to the Bank of England, always be prepared for surprises since the UK is also being hit by the US subprime problems. According to the Council of Mortgage Lenders, foreclosures have hit an 8 year high.

Employment Reports Expected from Canada, Australia and New Zealand Next Week
The Canadian, Australian and New Zealand dollars are slightly weaker today. Canada released much softer than expected IVEY PMI. Analysts were already looking for a 7 point drop, but instead, the index dropped a whopping 13.2 points. This indicates that the strength of the loonie is finally having a big impact on the Canadian economy. The drop in the employment component of the report also suggests that next week’s employment numbers will be weak. Australia and New Zealand will be releasing their own employment reports as well. The employment component of the stronger Australian service sector PMI suggests that the labor should remain tight. The New Zealand labor market should also hold steady.

Historical Movements of the Yen Crosses
Over the past week, the Japanese Yen crosses have moved in lockstep with the Dow and today was no different. With the exception of EUR/JPY and CHF/JPY, all of the other Yen crosses gave back its prior day’s gains. The growing problems in the US continue to weigh heavily on the market’s appetite for risk. Even though it may feel painful for carry trades at the moment, the 3 percent that we have seen thus far is marginal compared to how much carry trades have moved historically. There was not much Japanese Data to help the Yen this week but the week ahead is more promising with a relatively busy Japanese calendar, which includes the corporate goods price index.

Kathy Lien is the Chief Currency Strategist at FXCM.