By Kathy Lien, Managing Director of FX Strategy for BK Asset Management With disappointing economic data coming in from around the world, the currency and equity markets have been hit by another case of deleveraging. The performance of the dollar has been very erratic and dependent upon which country's outlook is uglier. While the greenback has fallen sharply against the Japanese Yen, it is steady against the EUR, down only slightly against the British pound and up sharply against the Australian dollar.
Broad based weakness in global data raises fresh concerns about recovery and growth but today, the focus is on the U.S. labor market and the potential outcome for Friday's non-farm payrolls. The ISM non-manufacturing index rose to 53.7 from 53.1 in May, reflecting a small increase in service sector activity. However any optimism was erased quickly when investors took a look at the employment component of the report, which declined from 52 to 50.1 last month.
As one of the market's favorite leading indicators for non-farm payrolls, the decline in this subcomponent of ISM could reset expectations for Friday's release. Up until now, economists were looking for payrolls to rise by 167K (from 165K the previous month) but looking at today's numbers, we feel that traders will adjust their positions to discount the possibility of a downside surprise. According to ADP, U.S. companies added only 135K jobs to their payrolls in the month of May. While this was more than the previous month, the increase fell short of expectations. The details of the report showed the service sector adding 138K jobs and the manufacturing sector shedding 3K jobs, the second decline in a row. With both the manufacturing and service sectors experiencing weaker job growth in May, the recovery in the labor market could be losing momentum. We will know for sure on Friday but right now, the price action in USD/JPY shows that traders are tapering expectations for Fed tapering. The Beige Book report will be released later this afternoon and this survey of economic conditions in the 12 Fed Districts will also help to shape expectations for payrolls and the outlook for monetary policy.
Meanwhile the persistent decline in Japanese stocks is weighing heavily on USD/JPY. The Nikkei dropped another 3.8% overnight, taking its total two-week losses to over 16.5%. Investors were disappointed by Prime Minister Shinzo Abe's structural reform agenda and its lack of new measures to overhaul corporate taxes, immigration and deregulation. As shown in the chart below, there is a very strong correlation between USD/JPY and the Nikkei. The recent decline is one of the primary reasons why USD/JPY has been selling off aggressively. The Bank of Japan won't be happy with the volatility in Japanese stocks and could attempt to stabilize the market by increasing the frequency of JGBs purchased next week. We can't imagine that the central bank would sit by idly and just watch Japanese stocks fall as quickly as they have without taking some type of action verbally or physically and action by the BoJ would help to stem the slide in USD/JPY.
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