Short But Busy Week For Dollar Bulls, Bond Bears

Currencies and equities are having a strong start to a shortened but busy trading week. With U.S. markets closed on Thursday for the July-4 holiday, volume in the financial markets will start to decline Wednesday afternoon and remain thin through Friday. Typically this means tighter ranges and lower volatility for currencies but this year with an ECB meeting and the non-farm payrolls report scheduled for release, the decline in volume could lead to greater volatility. In fact this week last year, EUR/USD dropped more than 400 pips to its lowest level in two years.

USD Focus
However the focus is on the dollar, which surged to new highs against many of the major currencies last week. Investors are still divided on when the Fed will taper -- September or December and the monthly labor market numbers will play a big role in shaping expectations for the currency and bond markets. The rally in USD/JPY today suggests that investors are positioning for a good jobs number after the Federal Reserve lowered its unemployment forecasts two weeks ago. We don't need much -- a small increase in non-farm payrolls and a steady unemployment rate or a small slowdown in jobs growth accompanied by a drop in the unemployment rate is all that bond investors need to drive yields to new highs. This is important for FX traders since they have been taking their cue from Treasury yields. There is a reasonable chance that the break of 100 in USD/JPY could occur before Friday's release, particularly since there are other key U.S. economic reports on the calendar.

Stronger-than-expected manufacturing activity in the U.S. helped to extend the gains in USD/JPY. The ISM manufacturing index rose from 49 to 50.9 in June, returning the sector to expansion after one month of contraction. The detail of the report were mixed. While prices, new orders, production and new export orders increased, the backlog and more importantly employment component of the report declined. In fact, employment conditions in the manufacturing sector contracted for the first time since September 2009. Underlying weakness prevented USD/JPY from immediately shooting higher to 100 but with time, we still expect this level to be hit.

EU Data
Meanwhile an upward revision to euro-zone PMI manufacturing number helped to keep the euro above 1.30 but a downward revision to Germany's report limited the rise. The Australian dollar on the other hand recovered from its initial decline after being hit by softer Chinese manufacturing numbers.

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.