Investors are snapping up U.S. dollars this morning as stronger non-manufacturing ISM and jobless claims fuel expectations for a solid non-farm payrolls report. EUR/USD dropped to a fresh 6 week low while USD/JPY traded above 100 for the first time since July 25th. Demand for the greenback is also supported by U.S. 10 year bond yields, which are also closing in on 3%. Service sector activity expanded at its fastest pace since January 2006 and more importantly, the employment component of the report rose to its highest level in 6 months. The ISM index increased from 56 to 58.6 in the month of August while jobless claims dropped to 323k from 332k. Fewer firings have not always translated into stronger hiring, but the improvement in ISM tells us that American companies in the service sector are increasing employment opportunities.

With such strong improvements in non-manufacturing ISM, investors will overlook the deterioration in the ADP and Challenger reports. Private sector payrolls dropped to 176k from 196k according to ADP while layoffs jumped 56.5%, a 15 month high according to Challenger Grey & Christmas. While the jobless claims figures may have been distorted by the Labor Day holiday because data from 3 states had to be estimated, claims fell to its second lowest level in 5 years with the less volatile 4-week moving average falling to its lowest level since October 2007. Continuing claims also declined by 43k to 2.95 million while non-farm productivity was revised up to 2.3% in Q2. We believe these signs of improving labor market conditions and expansion in the service and manufacturing sectors will keep the Federal Reserve on track to taper asset purchases this month. This means the potential for further gains in the dollar and yields.

The euro on the other hand fell to fresh lows after the European Central Bank repeated its pledge to keep interest rates low or lower for an extended period of time. The ECB has been uncomfortable with the rise in market interest rates and this concern is the reason why Mario Draghi is using forward guidance to reduce volatility and to contain the market’s overreaction to the recovery. Draghi may have started his press conference talking about the gradual signs of recovery, but he ended it with a firm warning that the Eurozone is not out of the woods. The best summary of Mario Draghi’s views was his response to a question about more rate cuts – he said the economy is too weak to exclude a discussion about lower interest rates and he doesn’t exclude the possibility of easing again if market interest rates move in an unsatisfactory way. In fact, he even said explicitly, that “we have a downward bias on rates.”

Inflation in general is subdued even though the central bank raised its 2013 GDP forecast and this lack of price pressure allows the central bank to keep monetary policy easy. More specifically, Draghi feels that while confidence indicators confirm that growth is improving, the risks to their outlook remain to the downside. The ECB raised its 2013 GDP forecast to -0.4% from -0.6% but lowered next year’s forecast to 1.0% from 1.1%. Monetary and credit dynamics remain weak and growth could fall short of their projections if commodity prices continue to rise, global demand softens, there is slow implementation of structural reforms and geopolitical tensions escalate.

The main takeaway from today’s meeting is that the ECB doesn’t want to be overly enthusiastic about the initial signs of life in the economy and with market rates headed higher, they are worried that higher borrowing costs could constrain the recovery. The ECB’s commitment to low interest rates should keep the EUR/USD under pressure as the Federal Reserve prepares to taper. The 38.2% Fibonacci retracement of the rally that took euro from its 2012 low to 2013 high is near term support for the currency pair and if this level is broken, the sell-off could extend to 1.30.

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