Dollar – Where is the Bottom?
Last week, we wrote “The rate cut issue may be settled once and for all after Non-Farm Payrolls next week. If the employment data once again produces the second sub-100K job performance in a row the rate cut will be almost assured. Despite the soothing rhetoric a weak July NFP would indicate that the economy was already slowing before the sub-prime mess became front page news and the markets will demand action from monetary authorities. Should that occur the greenback will likely weaken against the euro and the other high yielders as markets will begin to price in possibility of a change in policy towards a new loosening cycle.”

With the first negative print in NFPs in four years, the question of a rate cut appears to have been settled once and for all, although the Fed remains highly resistant to a systematic approach of lowering rates. Inflation continues to stoke the hawkish bias of US monetary policy makers, and with oil at $76/bbl and gold over $700/oz they can hardly be sanguine about pricing pressures within the US economy. Yet the Fed is caught between a rock and hard place. The employment data was so incontrovertibly bad that the risk of recession looms very real over the US economy, especially in light of the fact that most of the massive job cuts in the housing sector have yet to be recorded on BLS’s books.

For the first time in weeks, despite carry trade liquidation, the greenback actually lost ground against the euro and the pound, as the safe haven story started to fade and the currency market started to worry about the prospect of a US recession. Yet whether the euro or the pound will be able to maintain their gains against the buck will depend to a very large extent on how successfully the rest of the world will be able to decouple from the US slowdown. Once the US consumer goes, he may drag the rest of the G-3 with him especially if high exchange rates makes imports even less affordable. In short this dynamic could trigger a race to the bottom as every major central bank will scramble to lower rates to stimulate their economies with no clear winner in sight.

Next week, the market will pay very careful attention the Retail Sales numbers to gauge extent of the damage from the collapse of housing on US consumer spending . Yet this story is like a slow motion car wreck and will continue to unfold for months to come. We have the feeling that there will be quite a few more negative surprises to come.

Euro – How Much Power Left?
As expected the ECB left rates on hold given the turmoil that continues to play out in the European money markets where LIBOR rates have skyrocketed as complete lack of confidence in the creditworthiness of their counter parties has pushed three-month rates way above their historical levels. Against this background it was little wonder that Jean-Claude Trichet chose to stand down. Yet as we wrote on Friday, “Certainly one gets the sense that most of the G10 monetary authorities would like to hike rates further especially given the double digit growth in M3 monetary aggregates in both EZ and UK. However, the policy makers remain on the defensive due to the unrest in the markets. Indeed we think they will have to no choice but to be reactive rather than proactive, as investors deal with the growing losses in the sub-prime debt market and the concomitant problems of confidence in the money markets as key participants continue to be risk averse. “

Furthermore, signs that EZ growth may have peaked in Q4 of 2006 continue to present themselves. Nowhere was this more evident than in the latest German manufacturing data which saw orders drop the most in at least 16 years in July after a decline in sales of ships, trains and airplanes. Orders, adjusted for seasonal swings and inflation, fell 7.1% from June.

Next week the EZ Industrial Production data should provide more evidence to the market. If the EZ growth is indeed decelerating, euro’s strength will only come from its familiar position as the anti-dollar. Given such a dynamic the upside thrust may be decidedly limited unless US economic situation deteriorates rapidly.

Contraction in Japanese GDP Could Lead Yen Lower
The Japanese yen rocketed higher against the majors at the end of last week, as a strong pullback in US equities following the infamous NFP report sent USD/JPY and EUR/JPY reeling. In fact, USD/JPY ended the week down 2.1 percent, a significant drop after the pair meandered in range trade for most of the week. Economic data out of Japan, as usual, didn’t necessarily warrant gains for the low-yielding currency. First, capital spending during the second quarter unexpectedly contracted at a rate of 4.9 percent, after rocketing 13.6 percent during the previous period. The losses were generally contained to the previously-resilient services sector. As a result, Q2 GDP figures that were released just a week ago will likely be revised lower to indicate that the economy contracted. Meanwhile, wages in Japan fell at the fastest pace in three years during July, as monthly wages, including overtime pay and bonuses, dropped for the eight consecutive month at a rate of 1.9 percent. The Japanese labor market has been remarkably tight, but the failure of these improvements to translate into higher pay has hurt consumer spending growth, which accounts for more than a half of the economy, as discretionary income narrows more and more. Consequently, the nation has become even more reliant on exports, which are in danger at a time when the US housing recession threatens demand. Furthermore, the lack of wage growth has limited price pressures, leaving the economy teetering on the edge of deflation and hurting the Bank of Japan's case for enacting another rate hike in 2007.

Looking ahead to this week, economic data isn’t likely to play much of a role in price action for the Japanese yen pairs, as the condition of the equity markets should remain in control. Traders will probably remain jittery during the week, especially in the US, unless the Federal Reserve comes right out and gives the clear impression that they will indeed cut rates on September 18. Nevertheless, the economic data on hand at the beginning of the week will not help the case for investors remaining bullish on the yen, as the final reading for Q2 GDP could prove to be dismal. As we mentioned previously, the contraction in capital spending during the quarter is expected to lead expansion to be revised down to -0.7 percent. Though the Bank of Japan uses outlooks in order to make their policy decisions, they will not be able to ignore such dour economic conditions. With their growth forecasts likely to be impacted, the central bank truly has little room by which to navigate and BOJ Governor Fukui may not be able to enact further rate normalization as he so clearly desires.

BoE On Hold, Unusual Statement Guides Pound
There was a lot going on in the UK this past week. A healthy spread of regular economic indicators was biding currency traders’ time while they waited for the central bank’s rate decision at the end of the week. The economic calendar was evenly coated with second tier releases. The first half of the week was dedicated to PMI figures and a consumer sentiment report. In August, purchasing managers in both the manufacturing and construction sectors reported a pick up in activity. This was a promising contrast to similar reports in Europe and the US. The Nationwide Building Society’s consumer sentiment survey stayed out of the sterling’s way with an inline 94 print. The real fundamental action began, interestingly enough, only a few hours before Bank of England announced its monetary policy decision. An industrial production report for July unexpectedly contracted for the first time in five months, a lagging report (considering the PMI) but enough to rouse fundamental traders’ interest going into the rate announcement. When Governor Mervyn King officially announced the MPC’s vote to keep the overnight lending rate untouched at 5.75 percent, the market was ready to pass it off as a non-event. However, the committee didn’t leave it at that. In an extraordinary move, the BoE released a statement after announcing its decision. In the short memo to the public, policy makers offered a forecast for inflation to remain close to the 2 percent target ‘over the forecast period’ and easing growth. The real motive for the letter was clear a few sentences later though when they suggested concerns over asset-based securities was disrupting money markets. They went on to ensure that policy would be guided only by inflation; but they also said it was too early to determine how big of an impact the disruption in financial markets would have on the basic economic building blocks of growth and inflation.

The economic calendar for the coming week is distinctly front-ended. Monday opens with an upstream inflation release. The producer price index series’ August numbers are expected to see similar results to the previous month’s data. The output numbers will be key in shaping forecasts for front line price pressures. The greater market-mover for the week though will likely be Wednesday’s labor data. Official expectations for the net jobless claims, unemployment rate and earnings numbers are all expected to be unchanged. However, the greatest threat of event risk often lies in forecasts of complacency. With inflation cooling and financial market volatility soaring, it may only be a matter of time before firms rein in wage growth and job offers. While the market skips between these few scheduled economic indicators, savvy trader will also keep up on the BoE’s money market activity. Though the central bank left the overnight lending rate untouched, the MPC did promise to provide credit markets 4.4 billion pounds this week if money market rates held near their highest levels in 9 years.

Will the Swiss Franc Fall Back Despite a SNB Hike?
The Swiss franc rallied last week as national GDP unexpectedly accelerated, while a significantly weaker US dollar helped drive USD/CHF down 1.7 percent by Friday’s New York close. Economic expansion during the second quarter showed a 2.8 percent annual pace of growth, marking the fastest rate of expansion this year. However, Swiss growth is considerably cooler than it was in 2006, and with expansion cooling throughout the Euro-zone, Switzerland’s biggest trade partner, heady growth trends may be exhausted, especially if the recent global credit rout takes its toll. This less optimistic outlook is support by the recent pickup in the unemployment rate, which hit 2.6 percent, up from a five-year low of 2.5 percent. The question is: do current conditions warrant further rate normalization?

The Swiss National Bank will be the judge of that on Thursday, when the central bank is estimated to raise their target range for the three-month Libor rate 25 basis points to 2.25 – 3.25 percent. While headline inflation has remained remarkably tepid at an annualized rate of 0.8 percent, the import and producer price index recently hit 11 month highs, and these undercurrents have not escaped the vigilant eye of policy officials. Furthermore, recent volatility in the financial markets is unlikely to dissuade Roth from normalizing rates, as he said on August 20, “We hope that volatility stays higher. What we had was not normal, namely, practically no volatility…Markets cannot be a one-way street, or you will get excess.” With a 25 basis point rate increase priced in for the September meeting, traders will likely be proved correct as the Swiss National Bank keeps their rate normalization schedule intact. However, SNB decisions do not typically have a huge impact on the Swiss franc, but if we see the central bank shifts their outlook to reflect that they may stay neutral going forward, USD/CHF could see a decent boost.

Boris Schlossberg is a Senior Currency Strategist at FXCM.