US Dollar Rises as Jobs Fall, Markets Call for Fed Rate Cuts - Why? (Euro Open)

The Euro gapped down 112 pips at this week's trading open, opening at 1.3690 against the US Dollar versus Friday's closing price at 1.3802. With Friday’s disappointing Non-Farm Payrolls data and market expectations of dramatic interest rate cuts from the US Federal Reserve, why is the US dollar pushing higher?

Key Overnight Developments

• US Dollar Opens the Week 0.5% Higher Against Major Currencies
• Markets Unsure if US Rescue Plan Will Work – Risk Aversion Continues

Critical Levels 

The Euro gapped down 112 pips at this week's trading open, opening at 1.3690 against the US Dollar versus Friday's closing price at 1.3802. Sterling followed suit, gapping 103 pips lower and testing below the 1.76 level.

Asia Session Highlights 

The economic calendar faded into the background in overnight trading with virtually no significant event risk on the docket. Meanwhile, the broad US Dollar index saw the greenback open the week 0.5% higher against a basket of 6 top global currencies, continuing last week’s breakneck rally. At first glance, this seems puzzling:

First, Non Farm Payrolls disappointed expectations, showing the US economy lost -159k jobs in September versus the -105k forecast, the worst reading in 5 years.

Second, the market seems convinced that the Federal Reserve will cut interest rates  at their next meeting on October 29th. The question now, it seems, is by how much. According to the pricing of Fed Funds futures contracts, traders reckon there is a 84% chance that the Fed will slice 50 basis points off borrowing costs to put the benchmark lending rate at 1.50%. There is now even a 16% chance that rates will drop 75 basis points to 1.25%. The likelihood of either a "no-change" announcement or even a more modest 25-basis-point cut is seen as nil.

Finally, the dollar’s rise is unlikely to be related to cheering confidence in the final approval of the $850 billion rescue plan to shore up the financial markets by US lawmakers. Indeed, jittery investors unsure of the plan’s ultimate success have sent Asian stock markets into deep into the red while US equity index futures are down about 1.5% in overnight trading.

Conventional wisdom would suggest the US Dollar should be losing value on such news, so where is this strength coming from? The answer, it seems, lies in broad-based global demand for long-term US government debt. When investors become spooked by risky market conditions (as would be reasonable given recent events), they tend to move their capital from stocks and other higher-risk investments to long-term US Treasury bonds. While these offer very little return, they are considered nearly risk-free. The assumption is that such an investment can only go meaningfully awry if the government itself collapses. Comparing the EURUSD exchange rate with the US Treasury 30-year "Long" Bond, we see a staggering inverse correlation of 82% as of 10/03/08. This strongly suggests that the greenback is rising because traders are cashing in their investments for US dollars and using them to buy US Treasury Bonds as a safe-haven asset.

Euro Session: What to Expect 

With only minor event risk ahead for European trading hours, forex price action is likely to continue taking its cues from risk-related flows. Those releases that are scheduled to flash across the ticker are expected in line with themes familiar to traders over recent months: HBOS House Prices are seen lower in September as the UK real estate stump shows no signs of light at the end of the tunnel. In the Euro Zone, the Sentix Investor Confidence is expected to show sentiment at the lowest point in 5 years and the second lowest on record.

Meanwhile, traders are surely jittery after efforts by French President Nicolas Sarkozy failed to produce a unified European response to the credit crunch and its fallout: A meeting of key EU officials over and the top 4 European heads of state over the weekend produced little more than token statements of joint purpose. Just 24 hours after the summit, German Chancellor Angela Merkel conspicuously attacked the problem solo, with the German government announcing it would guarantee private savings accounts (to the tune of 568 billion euros) and pushing for a new 50 billion euro bailout for the country’s number-two property lender Hypo Real Estate Holding AG. 

To contact Ilya regarding this or other articles he has authored, please email him at ispivak@dailyfx.com.