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The Phantom Catalyst That Crushed the Dollar

The Phantom Catalyst That Crushed the Dollar

Kathy Lien, Technical Strategist

The US dollar was routed against major currencies on Thursday, and while several factors were to blame, it’s likely the liquidation was driven by advance fears about Friday’s US non-farm payrolls (NFP) report.

The big story Thursday in the financial markets was the selloff in the US dollar (USD). The greenback fell quickly and aggressively against all major currencies right around the European close and held on to its losses to end the day down 2% against the Japanese yen (JPY) and more than 1% against the euro (EUR), British pound (GBP), and Swiss franc (CHF). There were a few different factors behind the selloff.

The dollar initially traded lower on the optimistic comments from European Central Bank (ECB) President Mario Draghi, but those losses were contained to the EURUSD.

USDJPY did not see any losses until 90 minutes before the European close (noon NY time), and only when it started to break down did the dollar collapse against all major currencies.

We believe that the selloff was triggered by concerns about Friday's non-farm payrolls (NFP) report. European traders cut their positions before the close, and US traders joined the selling as stops were triggered in USDJPY.

By 1 pm ET, the moves settled and the major currency pairs remained confined in tight ranges into the US close.

Investors are growing weary of the outlook for the US and global economies, and are increasingly skeptical about the possibility of Fed tapering this year. While we still believe the US central bank plans to reduce asset purchases in September, the decision hinges in large part on Friday's NFP release.

Economists are looking for 165K jobs to be created, the same pace of growth as the previous month. The leading indicators for non-farm payrolls are mixed, which is why the chance of a miss is just as high as a surprise, although we lean towards a weaker outcome that could extend the losses for the US dollar.

The employment component of ISM is one of our favorite leading indicators for payrolls, and the big recent decline suggests that payrolls could be in the tens of thousands instead of 150K+.

Thursday’s dollar selloff suggests that some traders may have already priced in a weaker release, but we think there is still room for a downside surprise and further dollar weakness.

However, if payrolls surprise to the upside and print at 175K or better, all of the liquidation of dollar long positions that we saw today—particularly in USDJPY—could be reversed quickly and aggressively. In that case, USDJPY could trade back up to 98 in a blink of an eye.

Euro Bursts Higher as ECB Talks Recovery

The euro soared to a two-month high on the back of US dollar weakness and talks of recovery by the ECB. While the Bank left interest rates unchanged at 0.50%, slightly more optimism from President Draghi was enough to trigger a strong rally in the euro.

Draghi spent a bit more time this month talking about the improvements in economic data and their expectations for stabilization and a gradual recovery in 2013. However, he did not rule out the possibility of negative rates and instead made it clear that this option was discussed alongside others, and that all options remain on the table.

See also: The Key Takeaway from the ECB Decision

It’s Transition Time for Bank of England (BoE)

The British pound (GBP) extended its gains today against the euro and US dollar. As expected, Bank of England (BoE) Governor Mervyn King left monetary policy unchanged at his last meeting as central bank governor. Many BoE members said that the effects of the previous asset purchases are still coming to play, and those effects plus the recent Funding for Lending Scheme (FLS) should continue to bolster economic growth.

Although King is leaving his post as the economy is picking up, he says growth is not as fast as he would like it to be. It will now become the task of incoming BoE Governor Mark Carney to keep this pace of growth sustained.

The UK’s trade balance is scheduled for release on Friday. Given the uptick in manufacturing activity, we expect the trade deficit to narrow, which could compound GBPUSD gains.

The Other Big Job Report to Watch on Friday

The Australian (AUD), New Zealand (NZD), and Canadian (CAD) dollars all rebounded sharply on the heels of dollar weakness as well. The AUDUSD, which had fallen below 95 cents, is now trading back above 96 cents.

Unlike the Aussie, the rally in the Canadian dollar had underlying fundamental support as Canada’s PMI rose to its highest level in 14 months in May. Unfortunately, we are worried about slow job growth in Canada, and if tomorrow's Canadian employment report disappoints, CAD could resume its slide against the dollar.

No economic reports were released on Thursday from New Zealand, leaving the currency to take its cue from the Aussie.

3 Factors Killing the USD/JPY Rally

To say that Thursday was a volatile day for the Japanese yen would be an understatement. USDJPY dropped almost 3% intraday before closing down approximately 2%. Through the course of this selloff, USDJPY took out the 98, 97, and 96 levels.

While dollar weakness was the primary driver of the move, there's no question that the liquidation triggered stops that accelerated the breakdown. We wouldn't be surprised if some large funds got shaken out on this move as well considering the yen is more than 5% off its lows.

Bank of Japan (BoJ) officials won't be happy with the latest moves seen in the yen and the Nikkei. Japanese stocks have fallen close to 17% over the past few weeks, and the yen is up approximately 6%, both of which are bad news for Japan.

If stocks don't recover and the yen refuses to resume its slide before the BoJ meets next week, the central bank could be forced to take action to calm investors and reverse these moves.

In the meantime, the decline in US bond yields, persistent drop in the Nikkei, and the all-out lack of Japanese demand for foreign bonds is keeping USDJPY under pressure.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.