USD Gains As Sentiment Is Decidedly Bearish

FX traders remain focused on Friday's disappointing US payroll report and the growing prospect of further Fed action this month. Just to recap Friday, payrolls were limp with NFP unchanged on the month and private payrolls adding just a meager 17k.

The downward trend in hours and earnings continues to offset the lone bright spot in Household employment. This number, clearly highlights what analysts and even very late to the party politicians have been saying for a while now, that without jobs the US economic could never really recover. And now it seems that the US economic data is trending back towards recessionary growth territory. But with fiscal spending off the table for now (or at least we believe), it will be up to the Fed to attempt to stimulate real economic activity. While the disturbingly soft payroll read has increased the probability of more easing, which could be announced as early as Septembers FOMC meeting, we suspect that Bernanke will attempt to delay this policy tool. With limited tools left in the Fed preverbal tool box, there needs to be a certain amount of blind optimism considering how the first two rounds failed miserably. However, surely Bernanke understands that repeating the same actions and hoping for a different response it the definition of insanity. Barring more policy details from Fed members (obvious lack of details in August FOMC meeting minutes), duration adjustment to security exiting holding should be their next response. Further deterioration in US economic data reads or consolidated report such as this week’s Fed beige book, will increase the probability that the Fed will be forced into QE putting pressure on the USD. The initial react to Friday's read was mildly risk off, but we suspect that this is more of a reflection in recent volatility than a directional indicator. As we see further erosion in US data and as the Fed moves toward aiding the markets, watch for risk correlated trades being lead in FX by commodity, safe haven and Asian EM currencies to appreciate. We should also see a heavy pickup in selling demand on the USD from interest rate differential traders and a broad systematic risk event seeming unlikely.

While our expectations for the USD are low, our view on the EUR is decidedly more bearish. The problem is that economic weakness in the US will undoubtedly foreshadow further deterioration in the euro zone. And while the US theoretically has the mechanism to manage a downturn, Europe does not. With the combo of EU politicians returning from their summer holidays and resuming divisive debate on the sovereign crisis, coupled with the ECB's increasingly dovish language makes for further pressure on the EUR. This week brings critical data on the service sector (PMIs today), which expects to continue on the trend of weakness. A few headlines have already starting to put the EU crisis back in to the forefront of traders’ minds.

First was the news that initial exit polls from German local elections Sunday suggests that Chancellor Merkel’s ruling party is losing support over their handling of the EU sovereign debt crisis and slowing domestic economy. Second, was a media headline citing an unidentified senior IMF economist stating that Greece would likely face a “hard default” well before March 2012. But perhaps the most unnerving comment was from the S&Ps Moritz Kraemer, who suggested that if Eurobonds were developed then their rating would be based on the weakest rating of the group. This means that they would be given a Junk rating (although obviously markets would take that with a pinch of salt). The EURUSD most likely will be locked in a relatively tight range as the battle for the worst developed economy is a long term battle. However, the EURCHF is poised for a move back towards 108.

In Switzerland, the threat of SNB intervention or further action to weaken the CHF, has dissipated slightly and most believe that speculation of CHF peg is a low possibility event. In addition, there has been a recent change in official's tone, accepting that Switzerland must accept the strong CHF for the meanwhile.

Given the US Labor Day holiday trading activity should be confided to the European session. In the Euro zone, August composite PMI is expected to be revised down to 50.9 from 51.1 while EU retails sales is expected to come in a flat 0.0% from 0.7%. In the UK, markets are looking for services PMI to ease to 54.3 vs. 55.4 prior reading. As for the week monetary policy will be the dominate theme with a slew of G10 and EM central banks rate announcement on the docket.