Yield Spreads Are Favorable For Further Euro Strength

The dollar dropped to new session lows as the June ADP survey on private payrolls dropped 79K, versus expectations of an increase of 20K decline following a 40K increase in May.

Notably, the track record of the ADP survey in predicting the Department of Labor's private payrolls has faltered significantly over the last 4 months. DoL's initial readings on private payrolls showed -101K, -98K, -29K and -66K in Feb, Mar, Apr and May respectively, while the ADP private payrolls showed -18K, +3K, +13K and +40K. The considerable divergence of the last 3 releases means that a stronger than expected release yesterday morning may not be positively received by the dollar.

While much talk has been said about the recent inaccuracy of the ADP, we have yet to see whether the inaccuracy lies in the inability to predict weakness or the accuracy in predicting strength as was the case last year. At any rate, yesterday's report is consistent with the employment sub-index of the June ISM manufacturing survey, which tumbled to 43.7, the lowest since December 2001.

The Euro extended gains to 2-month highs against the dollar and 1-month highs versus the British pound on increased expectations that the ECB may leave the door open for further tightening after today's widely anticipated interest rate hike. The ECB's Trichet told Die Ziet newspaper yesterday that inflation may "explode" if the ECB does not master the situation with "decisive" action. The day's price developments remain about euro strength, rather than dollar weakness as the USD/JPY and sterling sustained heavy losses following a record decline in British construction activity. Modest dollar stability is accompanied by a retreat in gold and oil off their highs.

At 10 am yesterday, US factory orders were expected to have risen 0.5% in May following a 1.1% rise.

Euro Yield Spreads Suggesting Prolonged Robustness

Euro 10 and 2 year yields are advancing across the board relative to all major currencies, reflecting increased market expectations that the ECB will not make a one-and-done rate hike today. While we are well aware of the ECB's modus operandi of not pre-committing to future interest rate decisions, we do not expect Mr. Trichet to signal a "dovish" rate hike as that would risk a faster than hoped for decline in the euro, which would be exceedingly inflationary in a time of rising oil prices.

The counter-argument that a decline in the euro would bring about an automatic decline in oil prices is unsubstantiated by the fact that oil prices have increasingly proven to be boosted by fundamentals that are irrespective of USD dynamics.

The ECB has consistently raised its inflation vigilance up a notch in this year's press conferences and today's conference will not be any different. As for the evident signs of slowdown throughout the Eurozone, Mr. Trichet will likely continue to express those dynamics, but will keep them secondary to the upside risks to inflation.

EUR/USD powered ahead to $1.5850, but will face initial resistance at $1.5870. Key target stands at $1.59. The combination of ECB rate hike, press conference, US payrolls and weekly jobless claims could potentially call up $1.5950 and $1.600, but such gains are seen short-lived due to the risk of jawboning from US and European policymakers.

EUR/JPY: Risk Appetite or ECB Tightening?

The EUR/JPY rate has hardly reflected the yen's accumulating strength in the midst of the current blow to risk appetite as have other yen pairs (USD/JPY, GBP/JPY, CAD/JPY, NZD/JPY and AUD/JPY). Evidently, ECB rate hike expectations have been prominent in supporting the euro, but the key question is whether EUR/JPY will succumb to faster equity market losses and yen strength or break to new highs based on prolonged ECB hawkishness and the yen's commodity-driven weakness.

The chart below shows the clear relation between previous peaks in the EU-JP 10 and 2- year spreads, where a peak last summer coincided with the peak in the cross pair before giving in rapid deleveraging and volatility. We are not quick to conclude that the peak formation will be repeated because the yield spreads are led by the 2-year spreads (blue line), which is a reflection an increase in the benchmark interest rate set by the central bank as opposed to the long end of the curve.

Accordingly, EUR/JPY may be showing signs of a peak, but the ensuing trend line support (red) underpinning the pair suggests downside is limited at 166.30 and 167.00. The pair remains a strong candidate for any pick up in risk appetite or bear market rally emerging in stocks, at which point we're likely to see 169.40 and 170.00.

Prolonged Data Weakness Catches up with Sterling

Negative UK figures finally caught up with the British pound after the Chartered Institute of Purchasing and Supply's construction PMI dropped to 38.8 in June from 43 to reach its weakest reading since the survey began in 1997. All sub-sectors fell to record lows, with the housing sub-index dropping to 25.6 from 32.7. A figure below 50 denotes contraction. The report is out one day after the manufacturing PMIs fell to a 7-year low of 45.8 from 49.5. Facing increased chances of an outright recession, the Bank of England may have to give up its inflation to avoid a contraction, which would be the first in 17 years.

Cable dropped by more than a cent to $1.9848, after having failed to convincingly breach the 200-day MA of $1.9990 and the 50-week MA of $2.0020, which is also the 61.8% retracement of the $2.040-$1.9360 move. Any better than expected US jobs figures and/or dovish surprise from the ECB is likely to drag GBP/USD towards $1.9770, followed by 1.9680. Upside capped at $1.9890-00.

USD/JPY Capped at 107

JPY retreats across the board on a modest recovery in global equities and reports that the Japanese government will downgrade its outlook for the economy. Nonetheless, USD/JPY is facing increased resistance at 107.30, at which point we expect another signal of lower highs dragging the pair anew. Also remain alert for any reports indicating further term financing facilities from the Federal Reserve throwing a lifeline at struggling banks, which could trigger short-term yen weakness. Renewed downside is seen supported at 105.70, backed by 105.30.