Overview Ahead of US Employment Report

The US dollar is firmer amid last minute position agajust ahead of the employment data. With another round of asset purchases continues to seem probable, even though FOMC voting member Bullard and non-voting Dallas Fed’s Fisher indicated it is not yet a done deal.

Underlying sentiment is extremely dollar negative. In fact, the extreme sentiment readings and achievement of key levels, like $1.40 in the euro, $1.60 in sterling and JPY82 against the yen, is making the dollar bears uncomfortable going into the jobs report and the weekend G7/G20/IMF meetings.

While one must suspect a poor figure has been discounted, after the dismal ADP report, the failure to sustain the downward pressure on the dollar could be the first sign that that bears are getting tired. That said, short-term interest rate differentials between the US and Germany, which have been tracking the euro-dollar movement, is still struggling to stabilize, suggesting that dollar bounces will likely continue to be short-lived.

The US jobs data is likely to determine whether yesterday’s price action, which saw the dollar reverse to recoup its earlier losses than saw it make new multi-month lows against sterling and the euro, new multi-year lows against the yen and new record lows against the Swiss franc, is the beginning of a corrective/consolidative phase. The dramatic slide of the dollar over the past month has taken place with very few counter-trend days. In fact, out of the 19 sessions through yesterday, since the recent low was recorded on Sept 10 near $1.2644, the euro has declined in only four of those sessions. This has left the market over-extended. Sentiment readings also appear at extreme levels.

It is possible that the 1% pullback seen in the euro and sterling after the $1.40 and $1.60 levels were briefly breached yesterday could simply be the first leg of the correction. In terms of fundamentals, we identified the move in short-term interest rate differentials against the US as the key driver. These have continued to trend against the dollar this week, but with the 2-year US Treasury yield near 35 bp, much of the impact of the expected asset purchases appear to have already been discounted. Yet given the pace of the dollar’s slide, many will be inclined to chase the market and raise the forecasts for the foreign currencies. Since early September as it became clearer (to us) that QEII was likely we had suggested the scope toward $1.40 for the euro and $1.60 for sterling. Additional gains cannot be ruled out, but these may be better captured by momentum and other short-term traders. Medium and longer-term investors and other value traders should be wary of chasing the market.

Japan reported a somewhat smaller than expected August current account surplus. This is noteworthy in its own right as the balance of payments trade surplus narrowed to JPY195.9 bln from JPY916 bln in July. However, it is also a useful reminder of the changing composition of Japan’s current account surplus, which is important within the context of the talk of currency wars and competitive devaluations to boost exports. Nearly the entire JPY1.11 trilion current account surplus can be accounted for by the income surplus--the return on past foreign investment.

In addition, some details of its capital account were reported and it turns out that China turned to a net seller of JPY2 trillion of Japanese debt instruments. Actually after buying larger amount of Japanese bills in the May-July period, they were net sellers in Aug. China had been sellers of medium and longer term paper (e.g. sold JPY57.7 bln in July) turned to the buy since in August (JPY10.3 bln). The MOF data also suggests that Japanese investors bought JPY2.2 trillion of US Treasuries in Aug after purchasing JPY3.5 trillion in July.

In this context, note that the Federal Reserve custody holdings (of Treasuries and Agencies) for foreign central banks is surging. They rose $131 bln in Q3 and $143 bln in H1. In the first week of October, the data reported yesterday, showed a $21.5 bln increase (which is about $250 bln at a quarterly rate).