Euro Rallies as Trichet Leaves Door Open for Resuming Rate Hikes (page 1 of 2)

DailyFX Fundamentals 09-06-07

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar: Expect Only 25 and Not 50bp from the Fed

Although the focus in the financial markets is now on tomorrow's non-farm payrolls report, traders should not lose sight of the bigger question which is how much the Federal Reserve will cut interest rates later this month.

That is the only reason why NFP will be important, which is to act as a catalyst for the Fed. At this point, it is highly unlikely that the US central bank will forgo cutting interest rates since it is fully priced into the market and the consequences of not meeting the market's expectations could be even more serious than trying to delay the inevitable by another month.

The recent price action in the bond, stock and currency markets indicate that traders are nervous; everyone prefers to be in cash and gold with the price of the yellow rising significantly today.

If the Fed did not cut interest rates, they risk triggering a complete repricing of the interest rate curve and a sharp sell-off in the stock market. In reaction to that, the US dollar would rally and carry trades would collapse.

However even if we get a weak non-farm payrolls number tomorrow, a 25bp rate cut may be the best that the Fed will offer. The five Federal Reserve Officials speaking today held onto their belief that the problems in the US economy are limited and according to Poole and Lockhart, the US is near full employment, there is no major threat to job growth and no spillover from housing into the broad economy.

In other words, they will only back a quarter point rate cut. In the meantime, non-farm payrolls are still important because a weak number will drive home the point that the real economy is being affected regardless of what Fed officials are saying. The laundry list of why non-farm payrolls could be weak tomorrow is endless.

The employment component of the service sector ISM report released today dropped back into contractionary territory for the first time since September 2003 to match the lowest level seen since March of that year.

At that time, payrolls increased by a mild 81,000 in September and dropped by 196,000 in March. We expect non-farm payrolls to be less than 100,000 in August.

For more details on how non-farm payrolls could fare, see our special reports, August Non-Farm Payrolls: What to Expect for the US Dollar and How to Trade the US Non-Farm Payrolls through the EUR/USD.

Euro Rallies as ECB President Trichet Watches Economic Data

Even though the European Central Bank (ECB) left interest rates unchanged at four per cent today, the euro rallied as president Jean-Claude Trichet let the markets know that they have not given up on raising rates this year.

The turmoil in the financial markets is a big concern for them and they feel that it is important to make sure that confidence is restored in the markets. This morning, the ECB added another EUR42.2bn in emergency funds to calm the credit markets - a strong signal that their work is not done.

Yet fundamentally, for the time being, the ECB still feels that the medium term economic outlook is favorable which is why they believe monetary policy remains accommodative.