Today’s US session was one for those who enjoy watching paint dry. But tomorrow is NFP day and may be yet another day for a USD inflection point.

Today’s session was hardly one for the history books, though we did see fairly strong moves in NOK (in support of the interest rate spreads favoring the currency as we have noted in recent days) and in SEK off the back of the Riksbank interest rate hike and guidance. EURUSD and the other major USD pairs failed to follow up on yesterday’s exuberant move higher in respect of the upcoming US employment report and ISM non-manufacturing report tomorrow.

Nonfarm payroll expectations and reactions

Some have lowered expectations for US nonfarm payrolls due to the weak ADP release (soon we’ll be dropping the "private payrolls" figure, which remains the focus, once the rest of these pesky census workers are fired). The Saxo call (see a great report on the release here: is for a virtually unchanged figure versus a slightly more positive consensus. The market is already very short the USD, but risk is made a sharp comeback yesterday, which pushed the dollar lower. It feels like we’re in need of direction here after so many days of aimless trading in EURUSD and whippy trading in the more risk-correlated AUDUSD, but will we get any kind of resolution in tomorrow’s trading? It’s tough to build any conviction in this environment. For now, risk appetite measures are generally very complacent.

It is perhaps worth noting the reactions to the last three US employment reports.

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Risk sentiment surged on positive economic data as well as beginning of month asset allocation. The positive news stream continued from last night’s release of China’s August manufacturing PMI which surprised to the upside printing 51.7 vs. expected 51.5. The risk rally continued as we received uplifting news from down under on much stronger than anticipated 2Q Australian GDP numbers (+1.2% vs. +0.9% expected). The economic data out of the U.S. showed a disappointing ADP employment change for August dropping to -10K from the prior 37K (cons. 15K). This was the first negative ADP reading since January of this year. The market reaction to the labor data was relatively muted and it was the August ISM manufacturing data which was released at 56.3 well above the anticipated 52.7 and stronger than the prior 55.5. Construction spending came in weaker than forecasted (-1.0% vs. expected -0.5%) but was shrugged off as the market focused on the strong ISM numbers.

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• The ECB is taking a pause on the exit path. We expect the full allotment at all auctions to be extended until year-end and interest rates kept unchanged.
• As the risk of an economic downturn has increased we expect a softer tone at the press conference. Trichet is not going to announce new measures, but the door is still open.
• The staff growth forecast should be revised upwards – in particular for this year – while the inflation forecast should be kept practically unchanged.
• We expect a first interest rate hike from the ECB in Q4 2011. Current market pricing, based on EONIA forwards, suggests no hikes for the next couple of years.

Is Mr. Trichet still happy?

Will Mr. Trichet be as happy as he appeared at the last meeting? We believe not – US data have deteriorated a lot since the last meeting and it can only be a matter of time before the US downturn begins to drag on European growth. Nevertheless, the euro area did enter Q3 with strong momentum and seen from Frankfurt there is no cause for alarm yet.

Will the ECB prolong full allotment? We are pretty confident that they will – at least until the end of the year. This has already been indicated by Axel Weber in an interview with Bloomberg on 20 August 2010, see Flash Comment – ECB: No further exit before 2011. Financial markets are still fragile and there is no good reason to “rock the boat” before end-Q3 and before year-end, when liquidity tends to becomes more scarce. (more…)

Highlights

• Making lemonade out of lemons
• Important levels to watch
• Emergency BOJ meeting may hit the JPY
• Key data and events to watch next week

Making lemonade out of lemons

The past week saw a continuation of the stream of disappointing data out of the US and elsewhere, but around mid-week markets decided it was no longer a reason to sell risk. New lows were made in USD/JPY and the JPY-crosses early in the week after eye-popping declines in US housing data and a drop in durable goods orders. In Europe, comments from ECB and BOE officials warned of the real risk of a return to recession in the months ahead. European debt spreads continued to widen, with peripheral Eurozone (Ireland (credit rating cut), Greece, and Portugal) debt being sold and core Eurozone (Germany and France) bonds being bought on continuing fears of a sovereign default amid the worsening outlook. US Treasury yields dropped to new lows, with 10-year note yields touching 2.42% at mid-week.

But by the end of the week, it was all good. US weekly jobless claims declined, though they remain at highly elevated levels, and the revision to 2Q GDP was not as bad as feared, though it confirms the meager pace of the US recovery. In a much anticipated speech, Fed Chair Bernanke repeated earlier comments that the Fed stood ready to undertake further unconventional easing measures if the outlook deteriorates more significantly, but was short on specifics about what might actually trigger Fed action. Perhaps most significantly, he did not make a concrete commitment to another round of quantitative easing (buying US Treasury or other debt), which effectively pulled the rug out from under bond prices. Bond markets have been on a moon-shot in recent weeks and the lack of assurances from Bernanke that fresh buying from the Fed would soon materialize sent the longs dashing for the exits, sending 10-year yields up over 16 bps on Friday alone and more than 20bps from their lows. That move inspired further gains in USD/JPY and the JPY-crosses, sending them out with actual gains on the week. (more…)

U.S. Review

New Day Yesterday

• Subpar recovery in housing had been our expectation but this week’s existing and new home sales data reinforced that the old themes of consumer deleveraging and the long-term workout for the U.S. economy remain in place. Our outlook for the second half of this year is for sub 2 percent growth and housing continuing its slow workout.
• Disappointing durable goods orders are an issue, given our expectation that capital spending would be a major positive for growth this year.
• Real growth in the second quarter was revised down to 1.6 percent due to weaker trade and inventories.

Old Day Now

Economic readjustment continues to dominate any upside momentum the economy may have, and this is especially true for housing. Existing home sales dropped 27.2 percent in July, which was well below expectations. The monthly decline was the largest on record. Payback from the tax credit is largely responsible for the sizable decline. High inventories, at 11.9 months for single-family homes, continue to dominate home prices and buyer expectations. Combined with weak job growth and low consumer confidence, the case remains for a slow workout from the housing boom. Meanwhile, new home sales fell 12.4 percent in July, which was well below the consensus estimate. Prior months’ data were revised downward. The absolute level of sales dropped to a 276,000-unit pace, which is a record low. Unfortunately, median and average sales prices fell in July as well. (more…)

HIGHLIGHTS OF THE WEEK

• Post-tax credit U.S. home sales plummet by 27% in July, pushing inventories of unsold homes to a new peak of 11.3 months and renewing recovery fears.
• New orders of U.S. durable goods orders rose slighly by 0.3% in Jul. Core capital goods fell by 8.0%, pointing to a slowdown in the pace of equipment and software investment in the third quarter.
• U.S. second quarter GDP was revised down to 1.6% from a previously reported 2.4%. Revisions were in higher imports and lower inventory investment. Final domestic demand, including consumption and business inevstment where revised up.
• Fed chairman Ben Bernanke’s speech in Jackson Hole discusses the ins and outs of the options available to the Fed for supporting the economic recovery and stresses that deflation seems an unlikely outcome.
• Canadian retail sales slide 0.8% in Q2, marking the worst performance since the first quarter of 2009.
• Corporate profits in Canada were down 1.8% in Q2, ending a 3-quarter string of rising profits.
• The Teranet Home Price Index showed a 13.6% Y/Y rise in existing home prices in Canada in June.
• We have scaled back our Bank of Canada interest rate forecast. We now expect the overnight rate to sit at 1.00% at the end of 2010, and 2.00% at the end of 2011. (more…)

Framed by an United States housing market in far worse shape than previously expected, an American GDP revision not quite a poor as predicted, a German economy exhibiting almost 9.0% annual growth in the second quarter and widening sovereign spreads in Europe, currency markets choose the better part of valor and kept to a narrow two figure range all week. The slowdown in trading volatility cannot last; a new narrative will emerge in September. We have already seen a preview and it depends on the intensity of the US contraction.

If the US best economic news of the week is a choice between a second quarter GDP revisions down to 1.6% from 2.4% rather than to 1.4% and initial jobless claims at 473,000 rather than 490,000 the next leg down in the economy cannot be long delayed. But let’s look at some of the weeks’ statistics first.

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Market Outlook

Tactical view:

• GBP: selective gains targeted on AUD, CAD underperformance

Selling rallies in pro-risk and carry trade strategies is favoured in G10 currency markets and should translate into steady demand for safe haven harbours. We look ahead to next Tuesday when Japanese PM Kan will announce a plan to support the economy and tackle the JPY. With the SNB not explicitly targeting a level for the CHF, we wonder if safe haven dynamics may turn even more overwhelming in favour of long CHF positions. Next week also features US non-farm payrolls and the G7 meeting, promising a lively run in to September. If the relentless deterioration in the US economy observed this month is echoed in Friday’s non-farm payrolls, then a precipitous sell-off in risk and AUD, CAD and NOK could follow. For EUR/GBP to progress towards the June lows, we look for resilience in the UK August PMIs and the ECB to extend unlimited liquidity operations until year-end.

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