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Daily Currency Market Focus

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Dow falls 300 points, What's in store for the US dollar ahead of Payrolls?

Fri, Oct 3 2008, 12:23 GMT
by Kathy Lien

GFT

Even though the Senate has approved the newly revived bailout plan for the financial markets, equity traders are not convinced that the plan will be enough to rescue the US economy. In Wednesday’s edition of the Daily Currency Focus, we talked about how “on Monday when the markets opened, investors were not convinced that the $700B bailout plan would do the trick. Both US stocks and USD/JPY were sold long before the market caught whiff of the House’s rejection. Therefore it still remains to be seen whether the markets will have a positive reaction to the new bailout plan.” Our concern is that the US economy remains very weak and the crisis of confidence that has frozen the credit markets may not be solved by a plan that focuses on recapitalizing banks and not creating jobs. This has put the Dow within an arm’s reach of 10,000 as few hundred point swings have become the norm. For USD/JPY this also means renewed selling and a chance of slipping to 104.00.

What to Expect for Non-Farm Payrolls

This morning’s US economic releases continue to be weak with jobless claims rising to the highest level since 2001 and factory orders falling to a 2 year low. Recession fears are back and credited for today’s sharp slide in stocks, oil prices and the Japanese Yen crosses. Non-farm payrolls for the month of September are due for release tomorrow and now more than ever, the degree of job loss will determine where the dollar is headed next.

For the first time in this cycle, the market is looking for non-farm payrolls to fall by more than 100k. This would mark the ninth consecutive month of job losses. We believe that non-farm payrolls could fall as much as 130 to 150k. The 4 week average of jobless claims and continuing claims remain at 5 year highs. Claims are usually not subject to significant revision and are therefore very reliable leading indicators for NFP. Also, we have not heard the last of the layoff announcements. With market caps taking a bit hit and lending difficult to attain, US companies are tightening their belts and cutting back. With that in mind however, arguments can be made for an improvement in payrolls. Despite the turmoil in the financial markets, consumer confidence has improved, but the survey was closed before Monday’s 777 point drop in the Dow. The Monster.com employment index and the ADP report also points to a smaller drop in payrolls, but the reliability of ADP is in question and unfortunately the most reliable leading indicator for non-farm payrolls, which is service sector ISM will not be released until after the NFP report (Read our full NFP Preview).

How Non-Farm Payrolls Will Impact the Fed’s Decision and the EUR/USD

This time around, non-farm payrolls can determine 2 things – how much the Federal Reserve will cut interest rates and whether the EUR/USD will hit bottom. Here are the possible scenarios:

Payrolls Drop By 75k or Less: If payrolls drop by less than 75k, the Federal Reserve may postpone their interest rate cut or the best that we will get out of the Fed will be a quarter point rate cut accompanied by neutral comments. This would drive the EUR/USD towards 1.35 and help USD/JPY recover.

Payrolls Between -76k to -125k: If payrolls are anywhere between -76k and -100k, the Federal Reserve will probably cut interest rates by 25bp and hint that more easing may be necessary. This would keep the dollar under pressure against the Japanese Yen but it may not stop the EUR/USD from falling.

Payrolls Drop by More -125k: If payrolls drop more than -125k, there would be a strong case for either an intermeeting rate cut by the Federal Reserve or a 50bp cut at their scheduled meeting on October 29. As of 11:30am ET today, Fed Fund futures are pricing in a 90 percent chance of a 50bp rate cut in October and 10 percent chance of a quarter point cut (Fed fund futures can be very volatile). This would mean a bottom for the EUR/USD and further losses in USD/JPY.

The recent improvement in inflationary pressures makes it easier for the Federal Reserve to cut interest rates. The dovish comments by European Central Bank President Trichet suggests that if the expected approval of the bailout plan the House fails to stabilize the markets, there could be coordinated easing by the ECB and the Federal Reserve, which would be first in 7 years.

EURO HITS 1 YEAR LOW ON THE POSSIBILITY OF A NOVEMBER RATE CUT

The Euro fell to a one year low against the US dollar after ECB President Trichet buckled under the weight of bank failures, recessions and slower global growth. The central bank left interest rates unchanged at 4.25 percent, but for the first time in 5 years, there is a realistic chance that the ECB could cut interest rates in November if not sooner. Given the deterioration in economic data, bank failures and slower global growth, it was only a matter of time before ECB President Trichet would have acknowledged the slowdown and the need for easing. Today, he talked about the increase to downside risks and the reduction of upside price risks. Interestingly enough, in addition to his usual press conference and Q&A session, Trichet held individual interviews with reporters. This indicates that he is serious about getting his message across. He also wanted the citizens and the financial sector to realize that they can rely on the central bank to deliver stability. Trichet is not a fan of surprises and his actions today certainly suggests that he is preparing the market for an interest rate cut. At the meeting, only 2 options were discussed, leaving interest rates unchanged or cutting them - raising interest rates was out of the question. The market is currently pricing in 100bp of easing over the next 12 months.

Will an EU Bailout Plan Happen?

Meanwhile there has also been a lot of talk about an EU version of the TARP. As this is a crisis of confidence, it is important for the members of the European Union to signal that they will support the banking sector if another major failure occurs. However, if you think politics are a stumbling block in the US, it is even more so in Europe. The French have been calling for an EU bailout plan but the British and the Germans believe that each country should figure out its own solution. Earlier this week, Ireland announced that they were guaranteeing nearly all bank deposits and this morning, Greece followed suit. An agreement on banking regulations and individual solutions will be far more likely that an EU bailout plan.

Published on  Fri, Oct 3 2008, 12:29 GMT