Euro Slips after ECB Fails to Indicate that "Strong Vigilance" is Needed

DailyFX Fundamentals 07-05-07

By Kathy Lien, Chief Strategist of DailyFX.com

Non-Farm Payrolls Could Trigger Double Top in EUR/USD

Non-farm payrolls for June are due for release tomorrow and now more than ever, with the EUR/USD trading near its record highs, the amount of jobs created last month will be critical in determining where the dollar is headed next.

For the past few months, the stability of the labour market has pacified concern about the housing market, because as long as people have jobs, they will continue to pay their mortgages. However the problems in the housing market are worsening with sharp drops seen in existing, new and pending home sales during May.

In fact, pending home sales dropped by the biggest amount in more than five years, which means that the US economy could be in serious trouble if the labour market buckles. Thankfully, the labour market will probably be spared in June.

According to the ADP employment survey released today, private companies added 150,000 jobs last month, which is not only far stronger than the market's 100,000 forecast, but also represents the fastest pace of growth in seven months. Taken together with a 17 per cent drop in layoffs and a jump in the employment component of the service sector PMI report - we have the recipe for strong and healthy job growth.

Currency traders are already buying back dollars after this morning's upside surprises. Whether this is just a bump in the road to further losses for the dollar or a double top in the EUR/USD and GBP/USD will ultimately be determined by Friday's non-farm payrolls release. Even though the current consensus estimate for payrolls is 125,000, according to the Bloomberg survey, the range of estimates is between 80,000 and 150,000.

This divergence suggests that payrolls can be anyone's game, so as usual anticipate a volatile trading session tomorrow. For more on what to expect from the Non-Farm Payrolls release, see our Special NFP Outlook.

Euro Slips after ECB Fails to Indicate that "Strong Vigilance" is Needed

The European Central Bank left interest rates unchanged at four per cent and hinted that rates will continue to remain on hold at the August meeting.

Trichet did not use the words, 'strong vigilance' which has been code for 'expect a rate hike at the next meeting' and interestingly enough, he even pointed out that these words hold particular significance. The central bank clearly does not want to see the EUR/USD at 1.40 and Trichet even went so far as to say that 'we are in domain (in regards to exchange rates) where it is very important to be responsible'.

As an export dependent economy, a strong currency could eventually reverse the trend of growth. The futures curve is currently pricing in one interest rate by the end of the year. Trichet indicated that he does not want to alter the market's expectations for further tightening in September or October.

The level of overall inflation and oil prices will be extremely important in determining which month the hike will be delivered. Should oil prices skyrocket because of a surprise hurricane or something else to that degree, the ECB may have to act prematurely.

They already indicated that even though the August meeting will be held via teleconference, they will not rule out a press briefing or press conference to announce that "strong vigilance" may be needed once again.

Bank of England Raises Rates; Six Per cent Becomes a Possibly

As expected, the Bank of England lifted interest rates for the fifth time since last August by 25bp to 5.75 per cent. The price action of the currency pair indicates that the move was completely priced into the market.

The knee jerk rally was quickly reversed as traders came to the realisation that even if the Bank of England were to raise rates again this year, they would wait a few months before doing so.

In the accompanying statement, the central bank indicated that the inflation risks remains to the upside and they are concerned that it will remain above their target for some time. This is a clear signal that interest rates will be taken to six per cent this year and it is just a matter of when. Bond yields have moved higher on the back of the announcement, but having climbed significantly going into the latest rate decision, we could see a continued correction in the GBP/USD.

The minutes from this meeting will not be released for another few weeks - the balance of the votes will shed more light on how urgent the central bank is to raise rates again.

Canadian Dollar is Heading Back towards 30 Year Highs

The Canadian dollar is heading back towards its 30 year highs thanks to a sharp jump in manufacturing sector activity and building permits.

Contrary to popular belief, the Canadian economy has proved to be extremely resilient in the face of a strong currency. The details of the report were not as encouraging, but the headline number of 67.4 was still far stronger than the market's 61.8 forecast.

Building permits also jumped to a record high of 21 per cent, which was four times the market's forecast. At this point, all signs are pointing to stronger Canadian employment numbers tomorrow. The headline IVEY PMI index and the CAD employment number have a loose positive correlation.

Meanwhile the New Zealand dollar is also higher after reports that commodity prices increased in New Zealand last month. The Australian dollar did not participate in the rally after the government announced an increase to the minimum wage. Construction sector PMI is due for release tonight. The sharp drop in building approvals suggests that we could see continued weakness.

Carry Trades Continue to Take Yen Crosses Higher

Weaker than expected leading economic indicators in May sent the Japanese Yen tumbling against the high yielders. The carry trade is alive and kicking with AUD/JPY and NZD/JPY hitting fresh decade highs on an intraday basis.

Risk aversion is low and as long as it remains low, high yielding currency pairs will continue to benefit. The only thing that could put an end to this rally is a major sell-off in the equity markets around the world or some sort of significant geopolitical event.

The Japanese Yen will continue to be weighed down by the attractiveness of higher yields offer elsewhere and by the reluctance of domestic companies to pass on its profits to their employees.