USD: Sustainability of Rally Hinges on Payrolls

The first trading day of September has started off with a bang and we can only hope that the performance in the financial markets for the rest of the year will be as strong as what we have seen today. U.S. stocks closed up more than 2 percent leading to an improvement in risk appetite that drove all of the major currencies higher. Safe haven flows eased out of the low yielding currencies such as the U.S. dollar, Japanese Yen and Swiss Franc as stronger U.S. and Chinese manufacturing data alleviated concerns about slower growth in the fourth quarter. Although this helped to boost risk appetite across the financial markets, it was not enough to get investors to start buying dollars. The greenback only edged slightly higher against the Japanese Yen and Swiss Franc.

Countdown to Payrolls Begins

Non-farm payrolls are on the docket for Friday and investors are beginning to turn their focus to the labor market report. Whether or not the enthusiasm expressed by today's performance can be sustained will largely be contingent upon the outcome of Friday's release. If Friday's non-farm payrolls show a substantial increase in private sector jobs, then the Fed's pessimism may be overdone and the rally in risk will be sustained. However should there be a further deterioration, it would verify the Fed's concern for sluggish growth which could lead to further dollar weakness. The release of Census workers means net job losses in the U.S. economy last month but private sector payrolls (the more important figure) are expected to grow. Based upon the weekly jobless claims report and the ADP survey, the pace of growth should have slowed significantly even though the Challenger Grey & Christmas and the manufacturing ISM report still point to a positive number. Challenger Grey & Christmas reported a 54.5 percent drop in job cuts in the month of August which brought total layoffs to the lowest level in more than decade while the employment component of manufacturing ISM rose to the highest level in 26 years. However ADP reported a 10k decline in private sector employment which points to a negative private sector payroll reports while average jobless claims increased over the past month. Tomorrow's claims report will shed more light on whether unemployment rolls have continued to grow. Non-farm productivity, factory orders and pending home sales are also scheduled for release on Thursday.

Meanwhile the stronger manufacturing ISM report caught the market by complete surprise. The latest numbers show that manufacturing sector activity in the U.S. accelerated in the month of August with ISM rising from 55.5 to 56.3. The national release completely bucked the trend of the regional reports by showing more strength than weakness. It is extremely encouraging to see the employment component hit 60.1 (up from 58.6), matching its 26 year high and points to a similar improvement in manufacturing sector payrolls. After a series of disappointments and pessimistic comments from the Federal Reserve, investors really wanted some good news. However the underlying components were mixed with prices, production, inventories, imports and employment rising but new orders, backlog of orders, supplier deliveries and new export orders declining. This suggests that the acceleration in activity was due in large part to domestic and not external demand. Yet even though there are still many reasons to be concerned about the outlook for the U.S. economy, the manufacturing ISM report provided warm comfort for both currency and equity investors.

EUR: CAUTIOUS OPTIMISM EXPECTED FROM ECB

The euro extended its gains against the U.S. dollar despite weaker than expected German retail sales figures. The slightly stronger Eurozone PMI manufacturing report and the overall improvement in risk appetite contributed to the rise along with a strong vote of confidence from China. Premier Wen Jiabao, the leader of China said last night that China and Western Countries should work together to enhance the world's confidence in the euro and the European Union's economy. China will be working directly with Spain on this initiative as Wen invited Chinese investors to invest in Spain's financial, renewable resources and electric cars industries, the report said. According to the WSJ, Wen has made similar comments earlier this year on the euro's importance, such as in mid-July when he met German Chancellor Angela Merkel he said Europe remains a key market for China's foreign-reserve investment. China has said it aims to make better return on its vast holding of foreign-exchange reserves and ensure safety of its investment of the foreign-exchange assets and one way to do so would be to diversify out of US dollars and into euros. Despite the 0.3 percent decline in German consumer spending in the month of July, a strong upward revision to the prior month's report helped to offset any concerns that may have come off of the release. Eurozone GDP and producer prices are scheduled for release tomorrow and we believe that the data should help to fuel further gains in the euro after solid GDP reports from Germany and France. Overall, Eurozone economic data has been good and in fact, so good that German officials have suggested that it may be time to remove some easing measures as the recovery grows strength. The ECB has a monetary policy announcement tomorrow and even though they are not expected to alter interest rates, Trichet will deliver his usual press conference where we expect him to remain cautiously optimistic. Last month, Trichet said he expects growth in the third quarter to be stronger than previously thought but he quickly qualified this optimism by saying that the recovery will be uneven and that growth in the second half will be less buoyant than the second quarter. With more upside than downside surprises since the last monetary policy meeting, we believe that Trichet will hold onto this sentiment.

GBP: Shrugs Off Improvements

The improvement in risk appetite helped to lift the British pound higher against the U.S. dollar despite disappointing economic data. Manufacturing PMI for the month of August was expected at 57, down from July's 57.3, but instead printed a surprising 54.3, the lowest mark in more than 9 months. Though the above-50 number still signaled an expansion in activity, the economic recovery in the manufacturing sector seems to have lost its steam. Despite showing the fastest second quarter growth since 2001, the UK economy is failing to get on solid footing as huge public spending weighs down the pace of expansion. Such "market uncertainty" is only causing a further "slowing in sales growth" according to companies surveyed in the Markit/CIPS UK Manufacturing PMI report. On a positive note, UK manufacturers added jobs for a fifth straight month, though at its slowest pace for August, but still reflecting an increase in new orders demanded. While the country faces a $240 billion deficit, UK government officials are expected to announce further austerity measures when UK Chancellor George Osborne is due to release the final version of the government spending review on October 20 th . Measures could range from cutting state programs by 25% and some government departments by as much as 40%, in addition to the increase in VAT to 20%. Chancellor Osborne claimed these cuts will be both "progressive and fair" and though the UK government is truly using everything in its arsenal in an attempt to curb its deficits, questions still remain as to what such cuts will mean for UK growth going forward and how much of a financial burden such actions will have on already distressed UK households. Earlier in the week, we saw housing prices disappoint in a market that is having trouble finding new buyers. Investors should be looking ahead to Thursday's Nationwide Housing Prices to get a clearer picture of what's happening in the overall sector and how higher-than expected inflation in the UK is affecting the housing market. Moreover, Construction PMI due for release as well as statements from MPC member Tucker. Services PMI will be out Friday to wrap up the week.

AUD: Strongest GDP Growth in 3 Years

The rally in stocks drove the Canadian, Australian and New Zealand dollars sharply higher. There was no data from Canada but oil prices rose nearly 3 percent, its biggest one day gain since early August. New Zealand only reported a larger drop in commodity prices, leaving the market's focus on Australia. The second quarter was a particularly strong one in Australia with the economy expanding by 1.2 percent the fastest pace of growth in 3 years. This data confirms that China's demand for commodities has kept the Australian economy running on all cylinders. There is no question that Australia has one of the strongest economies in the developed world and this will most likely remain true for the near future. We have long been bullish Australian dollars and continue to believe that the currency could retest its August highs. However, it would be remiss for traders to completely shrug off the latest manufacturing PMI report which showed activity expanding by its slowest pace since March 2010. The PMI index fell from 54.4 to 51.7 due to a sharp decline in production and new orders. The hung Parliament has been blamed for the weakness, but a slower global recovery in the second half of the year also contributed to the weaker report. The latest GDP release will not be enough to push the Reserve Bank to raise interest rates. The Australian dollar remains in focus with Australia also being the only country reporting economic data this evening with the trade balance scheduled for release.

JPY: Upcoming Elections Could Pressure Kan to Intervene

The Japanese Yen weakened against all of the major currencies following better than expected U.S. manufacturing data. Speculation of intervention also increased when the Yen rose within 10 pips of its15 year high against the U.S. dollar. However Yen strength is not all bad as the currency's recent rally has given Japanese companies an increased amount of buying power in other countries, leading the number of M&A deals this quarter to increase 28 percent to over $22 billion so far from the previous quarter. If the latest Japanese Vehicle Sales report can be used as a gauge, then domestic demand is not all that anemic either. Vehicle sales rose by the largest amount since 1972 as buyers rushed to take advantage of government subsidies that are set to expire at the end of September.Meanwhile the former secretary general of the ruling Democratic Party of Japan, Ichiro Ozawa, has also begun his campaign against Prime Minister Naoto Kan. Ozawa pledged direct government intervention in the currency market in his policy platform stating "as for any sharp rises in the Yen from now on, I will decisively take all possible measures including market intervention to protect Japan's economy." Elections for the top DPJ post are slated for later this month and if Kan loses, Ozawa would become Japan's sixth Prime Minister in 4 years. If intervention is the platform that Ozawa is running on, then Kan may be pressured to act before the election if only to keep his job. Ozawa also promised 2 Trillion Yen or $23.7 Billion in economic stimulus, a measure double the size of that planned by Prime Minister Kan. To Kan's credit, however, he intensified his tone of Yen comments by telling reporters today "excessive movement in the currency market is bad for the economy and financial markets," and "I have the utmost recognition of this. We will take decisive action when necessary." Although exporters have increasingly expressed their concerns over the "out of control" appreciation of the Yen, the possibility of an intervention seems unlikely since a weak dollar helps the U.S. to maintain its fragile economic recovery through increased exports. Tohru Sasaki, a former Bank of Japan official who participated in the 2003 and 2004 interventions said that the government would "probably have to sell 50 trillion yen or 60 trillion yen, and it's not at all certain if even that would be successful."

EUR/USD: Currency in Play for Next 24 Hours

EUR/USD will be our currency pair in play for the next 24 hours. From the Euro-Zone, we expect the July Producer Price Index and revised 2 nd Quarter GDP figures at 5:00 ET or 9:00 GMT, followed by the European Central Bank's Rate Decision at 7:45 ET or 11:45 GMT. The United States is expected to release Jobless Claims and Revised 2 nd Quarter Non-farm Productivity figures at 8:30 ET or 12:30 GMT, followed by Pending Home Sales and Factory Orders at 10:00 ET or 14:00 GMT.

Rising for the second consecutive day, the EUR/USD remains within the Range-Trading Zone, which we determine using Bollinger Bands. The EUR/USD has broken out to the upside and rebounded strongly as with the most significant near-term support level at the 38.2% Fibonacci Retracement of 1.2776, drawn from the June low of 1.1876 to the August high of 1.3333, and which also coincides with the 50-Day Simple Moving Average. If this level is broken, the pair could see further support at the 1.2634 level which provided support for the most part since mid-July. The nearest level of significant resistance is at the 38.2% Fibonacci Retracement level of 1.2872, drawn from the August high of 1.3333 to the low of 1.2586. If this point is crossed, the pair should see further resistance at the 50% Fibonacci Retracement of 1.2960, which is close to the psychologically important 1.3000 level.