ECB and US payroll report key for dollar direction

ECB Preview
We would not completely dismiss the chances of an ECB rate cut. Recent comments from ECB sources have certainly prepared the ground. Soft inflation numbers last Friday (1.6% y/y in February) have provided a straightforward rationale. That said, there are three good reasons why the ECB is unlikely to move. First, the euro is not yet at 'danger' levels (>1.35 against the USD). The same ECB sources have said that the current level of the EUR is 'normal' given the twin deficits in the US. In fact the euro has been relatively stable against the dollar this year. On a trade-weighted basis (which is what really matters for the economy) it has weakened slightly.

Secondly, these sources have also said the ECB would like to see evidence of fiscal discipline and further progress on structural reforms. In other words, it does not want to ease the pressure on governments by cutting rates now. In this context, recent calls for rate cuts from France and Germany could actually be counter-productive: the ECB always pushes back against political pressure.

Finally, although Friday's numbers showed that inflation could be slowing a bit quicker than expected, the ECB had already forecast a fall below 2% this year. They are also preliminary estimates - we will not see the proper numbers (with breakdown) until 17th March. We do know that favourable base effects have helped (ie. big m/m increases in Q1 2003 are now dropping out of the annual comparison). These effects will end in March, suggesting inflation could be rising again in Q2. The ECB's preferred core measure - excluding energy and unprocessed foods - has been stubborn and was unchanged at 1.9% in January.

The ECB is therefore likely to stick to the line that interest rates are already low enough. Interest rate markets look vulnerable to disappointment, and the euro could get a brief lift.

US payrolls preview
As for the US numbers, it is important to stress that despite recent disappointments, payrolls are on an upward trend. February's payrolls should therefore be stronger than the +112k recorded in January. The ISM is already signalling monthly gains of 300k. Jobless claims and 'help wanted' have been more reliable in recent months, but they are now signalling gains of 150-200k. Friday's Chicago PMI also reported a big jump in employment. This came after a steady build up in the production component, which hit 76.5 in January before falling back to a still very strong 73.0 in February. This suggests that firms have reached the limits of their ability to squeeze more output from the existing workforce and are finally having to add jobs. Put another way, productivity growth is nearly exhausted, resulting in upward pressure on unit labour costs and inflation. Assuming this is replicated in the national ISM (today) we should get the first decent rise in manufacturing payrolls on Friday.

The recent fall in consumer confidence is more worrying. But the consumer surveys have a poor track record in predicting jobs data. Indeed, the responses on 'current conditions' may actually be a lagging indicator, reflecting whatever the media has been saying. The recent headlines have been dominated by talk of 'jobs lost' under Bush, the threat of 'outsourcing', and so on. This is certainly the 'mood of the moment', but it could change quickly as the jobs numbers improve. Note that weekly retail sales have continued to accelerate, despite the reported fall in consumer confidence, and on Friday the Michigan confidence data was revised higher.

Based on these factors, our forecast for February payrolls is +200k. This is well above the early consensus of +125k. We also expect the first m/m rise in manufacturing jobs in this cycle (+30k). We will review these forecasts after the February ISMs, but they are unlikely to change.

Turning to our Fed call, there are four payroll releases between now and the June FOMC. We expect at least three to show strong payroll growth (averaging 250k). Combined with rising inflation, this should prompt the Fed to raise rates in June. If February's payrolls disappoint again (say, <100k), and there are no offsetting factors, we would push back our forecast for the first US interest rate hike to August.