2 Dollar Moves 6 Weeks in the Making

DailyFX

Positive US economic data and divergent monetary policies between the Fed and ECB helped EURUSD retract to six-week lows today, while USDJPY took out 100 on news about Japan’s controversial sales tax.

Investors are snapping up the US dollar (USD) today after stronger non-manufacturing ISM and jobless claims fuel expectations for a solid non-farm payrolls (NFP) report tomorrow. EURUSD dropped to a fresh six-week low, while USDJPY traded above 100 for the first time since July 25.

Demand for the greenback is also being supported by US ten-year Treasury yields, which are closing in on 3%.

This morning’s data showed that service sector activity expanded at the fastest pace since January 2006, and more importantly, the employment component of the report rose to its highest level in six months. The ISM index increased from 56 to 58.6 in the month of August, while jobless claims dropped to 323k from 332k. Fewer firings have not always translated into stronger hiring, but the improvement in ISM tells us that American companies in the service sector are increasing employment opportunities.

With such strong improvements in non-manufacturing ISM, investors will overlook the deterioration in the ADP and Challenger reports. Private sector payrolls dropped to 176k from 196k, according to ADP, while layoffs jumped 56.5%, a 15-month high, according to Challenger Grey & Christmas.

While the jobless claims figures may have been distorted by the Labor Day holiday because data from three states had to be estimated, claims fell to the second-lowest level in five years with the less-volatile four-week moving average falling to its lowest level since October 2007. Continuing claims also declined by 43k to 2.95 million, while non-farm productivity was revised up to 2.3% in Q2.

We believe these signs of improving labor conditions and expansion in the service and manufacturing sectors will keep the Federal Reserve on track to taper asset purchases this month, which means potential for further gains in the dollar and Treasury yields.

EUR/USD Falls to Fresh Lows

The euro (EUR), on the other hand, fell to fresh lows after the European Central Bank (ECB) repeated its pledge to keep interest rates low or lower for an extended period of time. The ECB has been uncomfortable with the rise in market interest rates, and this concern is the reason why ECB President Mario Draghi is using forward guidance to reduce volatility and contain the market's overreaction to the recovery.

Draghi may have started his press conference by talking about the gradual signs of recovery, but he ended it with a firm warning that the Eurozone is not out of the woods. The best summary of Mario Draghi's views was his response to a question about more rate cuts, when he said the economy is too weak to exclude a discussion about lower interest rates and he doesn't exclude the possibility of further easing if market interest rates move in an unsatisfactory way. In fact, he even said explicitly that "we have a downward bias on rates."

Inflation in general is subdued even though the central bank raised its 2013 GDP forecast, and the lack of price pressure allows the central bank to keep monetary policy easy. More specifically, Draghi feels that while confidence indicators confirm that growth is improving, the risks to the outlook remain to the downside. The ECB raised its 2013 GDP forecast to -0.4% from -0.6% , but lowered next year's forecast to 1.0% from 1.1%. Monetary and credit dynamics remain weak and growth could fall short of projections if commodity prices continue to rise, global demand softens, there is slow implementation of structural reforms, and ongoing geopolitical tensions escalate.

The main takeaway from today's meeting is that the ECB doesn't want to be overly enthusiastic about the initial signs of life in the economy, and with market rates headed higher, policymakers are worried that higher borrowing costs could constrain the recovery.

The ECB's commitment to low interest rates should keep the EURUSD under pressure as the Federal Reserve prepares to taper. The 38.2% Fibonacci retracement of the rally that took EURUSD from its 2012 low to 2013 high is now the near-term support for the currency pair. If this level is broken, the selloff could extend to 1.30.

By Kathy Lien of BK Asset Management

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