USD Starts 2011 Weak, As Risk Appetite and Carry Trade Dominate

The currency markets have been in a sell-USD mode in January, as strong global equities helped spur risk appetite and investors used the USD as a funding currency for carry trade.

That environment of USD weakness is also being fed by the FOMCs statement in their January 26th meeting that they were going to stay the course with their loose monetary policy and second round of Quantitative Easing as growth is not enough to help bring down the unemployment rate and it still sees underlying inflation weak. IT was an admission that the Fed is sticking to their policy, no matter how strong US economic data looks.

That puts the Fed behind other central banks like the Bank of England and the European Central Bank which have made their country's inflation data a big story the last two weeks.

Does Recent Positive US Macro-Economic Data Point to More Jobs Gains?

But, the disconnect between strong US data - like a pick up in the manufacturing PMI in January - have not helped the USD to rally. It's been the political instability in Egypt which has for the most part supported the USD. That was until today's less hawkish than expected ECB statement and Trichet conference which dented the EUR.

But can the Fed's minds change quickly if we start to see improvement in the labor market? That could spell a quick turnaround for the USD, if in fact we have a stronger than expected non-farm payroll report for January. In the ISM Manufacturing data we saw the employment component rise to its highest level since 1972, and the ADP employment change figures also saw positive private sector growth of 187K. While the ADP data has not been a good indicators for what the non-farm payroll will tell us, it's still improvement.

If Employmnet Data Surprises, Will Fed's Policy Change Quickly?

While the official figure expected for tomorrow's  Non-farm payroll report is for a print of around 130K, anything above 170K could help the USD's position. Such a reading would mean that the labor market is in fact thawing, and the positive US data can finally be seen impacting hiring.

The reason that better than expected non-farm payroll data can sway the Fed's thinking is that the conventional wisdom right now is what the Fed has said: growth is too weak to bring about meaningful job gains. Fed forecasts have the unemployment rate remaining near 9% by the end of the year.

If that caveat is proven false and we have to start considering a more hawkish FOMC, with its recently positive macro-economic data it could mean some flows return to the USD.

Helping that cause would be an increase in the 10-year yields, which have been stuck in a narrow 3.30% to 3.55% range. But as we see inflation picking up, then yields may go higher as well.  Such a development would put increased pressure on the Fed to raise interest rates as well.

While tomorrow's data, if stronger than expected, could increase speculation about tighter monetary policy.

If we meet expectations, then the dynamic that we have currently - with the USD weaker during times of risk appetite - will continue.

If payrolls come in weaker than expected 50K or below, then we are in a whole different ball game, and its looks like the Fed may in fact start debating if even more quantitative easing is needed. That would doom the USD to weakness for the rest of the year. The other data we have been seeing tells us that this 3rd scenario is least likely.

Therefore we look forward to tomorrow's report as we know it is one the most important reports that the Fed is watching when it comes to its monetary policy.