Dollar Drops as Labor Slumps
For the first time since February, Non-Farm payrolls printed below 100K raising the specter of a serious slowdown in the US economy that may force the Fed to consider lowering rates before the end of the year. Certainly on the surface the news appears to be rather bleak as the unemployment rate picked up as well and the month’s prior numbers was revised downward. The only bright spot in the report came from manufacturing which contracted only -2K jobs versus forecasts of -18K. It appears as through manufacturing is the sole beneficiary of the lower dollar, yet even in that sector the ISM survey printed worse than expected coming in at 53.8 versus 55.0 projected.

Overall US data was decidedly dollar bearish with Consumer Confidence the only unambiguous positive report for the week. Yet the readings were taken before news of further turmoil in the housing sector and the dour jobs data, so it remains to be seen if the US consumer will hold up. Given the preponderance of evidence so far, it seems unlikely at best. Next week the only event of note is the FOMC meeting. While few analysts expect the Fed to cut rates - indeed a cut next Tuesday would border almost on desperation likely sending markets into turmoil – any change in the language by Dr. Bernanke and company that acknowledges the growing problem in the credit markets be viewed as precursor to a rate cut and could cause further dollar selling.

The one bullish argument for the dollar comes in the form of a back handed compliment. Some analysts argue that the credit crunch and the unwind of positions will create a bid for the dollar as all capital becomes parked in short term Treasuries. Thus, contrary to the popular view that growth differentials will hurt the greenback this thesis basically says the buck rises on safe haven flows. While the safe haven idea is plausible it likely to have only have only temporary effect on trade. If US economy truly slows and rates start to fall the dollar will weaken irrespective of the safe haven bid.

Euro Back to the Anti Dollar
The news from the Eurozone provided little excitement last week as the regions data printed broadly in line. The wear and tear of the appreciating currency was seen in the PMI Manufacturing figures which slipped below - 55 their lowest reading in more than a year. Furthermore the EZ consumer demand continued to lag with both German and EZ Retail Sales data missing targets. However, despite the generally softer tone of the releases, euro received a boost from the ECB late in the week when the President Jean Claude Trichet stated that “strong vigilance” was essential to guard against excessive inflation. This language has signaled a 25bp rate rise the following month ever since the bank started tightening in late 2005. There was some speculation that ECB would hold off on a rate hike until possibly October, thus Mr. Trichet’s assurance of a September tightening served to assure the euro bulls that a hike is in place.

However, with 4.25% rates widely expected and priced in, the news from the Euro-zone is unlikely to have any strong impact on trade. Next week’s EZ calendar only carries Industrial Production and Trade Balance data neither of which will have material impact on price. The EURUSD is much more likely to trade off the developments on the US side of the Atlantic as the euro resumes its familiar position as the anti-dollar. The economic calendar clearly indicates that we are in the dog days of summer and after several weeks of volatility perhaps some respite is due.

Japanese Yen Gains Remain Dependent Upon Risk Aversion
Risk aversion trends have kept the Japanese yen relatively strong against the majors, with USD/JPY continuing to follow the movements of US equity markets quite nicely. For example, last Tuesday’s 146 point plunge in the Dow and 18 point drop in the S&P 500 coincided with a 100 point tumble in USD/JPY from resistance at 119.35. True, economic data out of Japan was consistent with a bid tone for the oft-beleaguered low-yielder, but price reaction was minimal upon the actual release of the figures. When industrial production surprisingly surged and when the jobless rate unexpectedly fell to a nine-year low of 3.7 percent, USD/JPY barely budged. As it stands, there are really only two fundamental events that could perpetuate a strong move by the Japanese yen: a rate hike by the Bank of Japan or a jump in inflation. Until then, the pair will remain at the whim of carry trade flows, so traders should remain alert to the risk aversion trends that have recently contributed to USD/JPY weakness.

Nevertheless, traders should be aware of the Japanese economic data on tap this week, as the results could have an impact on future policy decisions by the BOJ. The Leading Economic Index is anticipated to rebound in the month of June, but the figure tends to be revised frequently, minimizing the impact of this particular indicator. Machine orders are estimated to show a drop in demand, signaling that business investment continues to slow. This was made evident in recent GDP reports, though the slack in capital expenditures was made up by consumption, which isn’t entirely surprising given the tight conditions of the labor market. Regardless, this pick up in spending has yet to filter into price growth, leaving prospects for further rate normalization very low. However, with the recent political turmoil created by the DPJ’s win for the majority of the Upper House possibly distracting the LDP from the central bank’s policy actions, there is the potential for a hike by the BOJ in September.

British Pound Gains Steam, But Are Declines In Store This Week?
The British pound was a consistent gainer over the course of the last week, as GBP/USD ended the week by testing the 2.0400 level. The move came on the back of dour US data, which was not entirely surprising since Cable price action was generally determined by the greenback for the entire week. The Bank of England’s rate decision resulted in little price action, as the Monetary Policy Committee left the benchmark steady at 5.75 percent, as expected, after enacting a 25 basis point hike last month. While the BOE’s 2007 tightening cycle has started to become more restrictive as it takes its toll on inflation, the housing sector, and consumer sentiment, the fact that CPI is still above the bank’s 2.0 percent target has left the markets pricing in one more hike to 6.00 percent this year.

However, this week’s Quarterly Inflation Report could determine the direction of Cable, as BOE Governor Mervyn King’s delivery of the report will make the bank’s inflation stance far clearer. If King continues to highlight the upside risks to price stability, as European Central Bank President Jean-Claude Trichet did last week, traders will ramp up speculation of a September hike to 6.00 percent. The release of the minutes from the August policy meeting on August 15th will be the other important gauge for the bank’s next move, as just a few votes for a hike will assert that hawks remain on the MPC. On the other hand, a more neutral tone in the Quarterly Inflation Report along with a unanimous vote in the meeting minutes will defer hike expectations until later in the year. In the typical “buy-the-rumor sell-the-news” price action we see so often in forex markets, the most likely scenario for GBP/USD may result in a determined bid tone ahead of Wednesday’s Inflation Report, but end with a subsequent sell-off. According to our Technical Strategist, Jamie Saettele, traders may want to “Look for a terminal thrust from this triangle into 2.0400/73 before a reversal… against 2.0654, targeting a drop under 2.0181.”

Swissie’s Sensitivity To Risk Produces Big Gains
In the scheme of things, the franc is the FX traders’ second favorite funding currency (behind the Japanese yen). This gives the unit a unique sensitivity to big swings in risk aversion and appetite that cross asset boarders. Recently, this has made the currency valuable in the carry trade unwind. When risk aversion is stoke; the franc’s momentum presents an attractive trade. This past week, the mood towards risk has swung between extremes. Earlier in the week, cooling anxiety in international government bonds, equity benchmarks in the major financial hubs, and the Japanese yen put a stopper in the franc’s volatility. A complete 180 was turned in the closing hours of Friday when equity declines forces ripples throughout international markets and onto the Swiss currency. During the lull, as the winds of risk died down, the heat from the economic calendar was ready to fill in for fundamental swissie traders. Three top market-moving indicators crossed the wires last week – a heavy week for Switzerland. The action began on Tuesday with a modest rebound in the UBS Consumption Indicator. The proprietary indicator was thrown off its trend in May when it fell of its recent historical high. A June recovery held bulls attention though as the unflappable labor market encouraged purchases of large objects like autos. Not two days later, an SVME PMI report for July kept the ball rolling for the manufacturing group. The 63.0 print, a five-month high, was founded on a pick up in production and orders. And, whereas both of the aforementioned indicators likely added to SNB rate speculation; the CPI numbers likely had very little impact. Inflation contracted for the first time in six months in July, though the annual figure accelerated to a 10-month high 0.7 percent. However, this adds up to very little as the central bank has maintained its aggressive policy stance through its cycle with price pressures well below its 2.0 percent target.

Looking ahead at this week’s listings, the calendar could hold the reigns on the swissie. The data begins with Wednesday’s labor report. The official consensus gives little to go on as economists are expecting the jobless rate to hold at its five year low. Realistically though, even if the report puts in for a new low, traders would likely shrug the data off since they have come to expect the strength. On the other hand, an unexpected rebound in the jobless rate could place a disproportionate weight on the franc for the same reasons it would not rally on an improvement. The second indicator to cross the wires is the quarterly SECO consumer confidence number. Optimism hit a six-year high in the quarter through April and forecasts are projecting this period’s number to only improve upon the trend as employment, spending and growth brighten the consumer’s outlook. While the scheduled fundamentals will take their place over the coming days, a leery should always be kept on the health of risk appetite, especially in the wake of Friday’s dramatic price action.

Canadian Dollar Shows Fleeting Signs of Strength
The Canadian dollar finished slightly stronger for the first week in four, as sharp declines in its US namesake left the USDCAD at its worst since July 26. Loonie bulls took charge despite mixed economic data; a below-forecast Gross Domestic Product result and soft Industrial Product Prices hurt interest rate expectations for the world’s eighth-largest economy. The former showed that the Canadian economy rebounded from April's deceleration in growth, printing a 0.3 percent month-over-month expansion rate in May. This was largely due to services sector expansion, including retail sales which grew at their fastest pace since November of 2001 and Wholesale Sales at an impressive 1.4 percent. Manufacturing was comparatively tame but still respectable, gaining at a 0.3 percent rate. The change in Industrial Production was perhaps the only disappointment in the mix, as the sector dropped 0.2 percent on May. This likewise fed into a softer Industrial Product Prices report and moderated outlook on inflationary pressures across Canada. The net effect of the mixed economic data was to limit interest rate expectations through the end of the year. Futures traders subsequently sent implied rates for December to a meager 4.85 percent—showing a very low probability of more than 25 basis points in rate increases through year-end. Given that this was a key pillar of support for the Canadian dollar, the Loonie stands to lose further ground against major counterparts absent a reversal in interest rate trends.

Whether or not the Canadian dollar changes course will largely depend on upcoming housing and labor figures, making it a make-or-break week for Loonie bulls. Friday’s Net Change in Employment report will be the clear highlight on the week, and consensus forecasts show that analysts expect that the economy slowed jobs growth in July. Median estimates at 22,000 newly employed nonetheless remain above longer-term trends, but a disappointment could clearly drive further Loonie tumbles. The previous day’s Housing Starts data may likewise have an effect on the USDCAD’s overall trend. Forecasts call for weakness in both new construction and a deceleration in price growth, but a resilient real estate market threatens to beat the street’s estimates. Otherwise, the Canadian dollar will trade off of developments in its southern neighbor; Tuesday’s US Federal Open Market Committee is highly likely to have a strong impact across all USD pairs. Dollar weakness could once again trump the Loonie’s pullbacks—making it critical to listen to the statement following the FOMC meeting.

Australian Dollar Readies For Rate Hike, But Uncertainty Looms
Though the Aussie dollar didn’t cover much ground this past week, the currency’s fundamental cup was overflowing. A healthy mix of indicators, with prints that stoked bullish and bearish fervor, helped to stabilize the currency following a period of selling that was swept up in a wave of risk aversion. Looking back over the packed calendar, there were top-tier indicators for nearly every major vein of data. The business sector was well covered by second quarter confidence and outlook figures. According to the NAB, executives were the most optimistic about business conditions and profitability in nearly four years. The forecast was even brighter as the Condition’s Outlook report touched its highest level in the indicator’s 18 year history. Alternatively, a June trade deficit of A$1.75 billion foreshadows business leaders’ rosy outlook may be for naught. The biggest shortfall in over a year was facilitated by a sharp drop in exports caused by cooling growth abroad, a high exchange rate and disruptive storms through the month. More important to the market though was data measuring the consumer’s health. A sign that Australians are coping with higher interest rates, both building approvals and new home sales improved over June from a readings a month ago. However, most highly anticipated data for the week, that of retail sales, was left impotent by conflicting numbers. The bullish sentiment garnered from a 1.4 percent increase in receipts through the month of a June (the biggest in over two years) was swiftly stifled by the first quarterly decline in two and a half years and the biggest drop since 2000.

Considering last week’s numbers, the case for Tuesday evening’s (early Wednesday for Australia) RBA rate decision is certainly not open and shut. As it stands, 20 of 25 economists surveyed by Bloomberg are expecting a quarter point hike to 6.50 percent. This would be the first shift in the benchmark rate since November. On the one hand, hawks would say healthy business conditions, a big 1.2 percent increase in second quarter CPI, an unemployment rate at a 33-year low and the pick up in consumer spending in June are confirmation that monetary policy is too accommodative. Alternatively, doves can counter with equally valid arguments. To refute the spending case, the pick up in retail sales was in June alone, while the quarterly number actually dropped, suggesting an overall degrading trend. Another counterpoint is that inflation is actually rather stable with an annual 2.1 percent pace of growth that is almost exactly dead center of the central bank’s 2 to 3 percent target band. Whatever the outcome, there is likely enough uncertainty in the market that the event will produce interesting price action. And, looking at the docket, the action won’t end with the central bank. A quarterly housing inflation number is penciled in shortly after the rate decision. Perhaps more provocative though will be the July employment data. Following a disappointing 2,500 person increase in payrolls, a 25,000 pick up is expected to put the indicator back on track. Still, the jobless rate is forecasted to increase.

Kiwi Loses as Carry Trade Unwinds Further
The New Zealand dollar fell for the second consecutive week of trade, suffering from a continued carry trade unwind and setting fresh monthly lows against its US namesake. Economic data was limited to a second-tier NBNZ Business Confidence report, which unsurprisingly showed that optimism dipped on record-high domestic interest rates. The big story on the week was of course continued tumbles in global equity markets. The US Dow Jones Industrial Average finished the week at a whopping 5.2 percent off of recent record-highs, leaving continued risk aversion at the forefront of traders’ psyches. High-yielding currencies such as the New Zealand dollar suffered as a result, and the carry trade set fresh drawdown lows through Friday’s close. Outlook for the New Zealand dollar is clearly linked to the overall performance of risky assets, with a coming week of strong event risk to likewise force volatility in Kiwi pairs.

Failing interest rate expectations could potentially reverse course on upcoming economic data, with Wednesday night’s Employment Change data to potentially change the Reserve Bank of New Zealand’s stance on the future of inflation. As we highlighted in last week’s report, RBNZ Governor Alan Bollard effectively told markets that four consecutive rate increases may be enough to limit consumption and inflationary pressures. Yet stronger-than-forecast economic growth and wage inflation could easily deter the central bank from taking a more neutral stance on price pressures. If we see the kind of positive surprise markets have grown slowly accustomed to from the New Zealand economy, the Kiwi could easily benefit from higher interest rate differentials against major trading counterparts. Of course, this may all come to little if the global carry trade does not rebound. Given a dismal performance in risky assets on the week, we feel as though the carry trade drawdown may reach further lows before recovering through the medium term. Our recent special report highlights the fact that the carry trade unwind remains small by historical standards and leaves ample room for declines.

It will subsequently take a rebound in equities and strong employment to reverse the Kiwi’s course, leaving NZD bulls with little foreseeable support through short term trade.

Boris Schlossberg is a Senior Currency Strategist at FXCM.