Forex - USD Rallies Back on Stronger US data

There has been a stark change in the markets’ sentiment regarding the USD since last Thursday. The obvious question is: is this shift a complete reversal or just a temporary correction before a continued USD weakness? The markets reaction to the large upside surprise to private sector payroll employment (improvements across all sectors) seems to us slightly misguided. The USD initially sold off but then rallied back as NFP printed at -345k vs. -520k exp (although the official unemployment rate edged disturbingly higher). The stronger data in a critical component of the US recovery story has increased speculation that the Fed will begin unwinding of liquidity measures, through tighter monetary policy, by years end. We are unconvinced that the recovery will be fully entrenched or that inflation levels will become (in that period) so worrying that the Fed would be willing to take this action. However, with Trichet clearly stating that the ECB would be looking to begin draining liquidity soon, markets have now begun to think about a world without central bank super liquidity (anecdotal support materialized and provided yields in the US Treasuries with firm footing, which were pushed higher after the NFP number). On a side note, over the weekend Chancellor Merkel's party did very well in the European elections and we expect her criticism of major central banks, before German elections in the fall, to increase. In addition, the UK's labour Party faired poorly. However, Prime Minister Gordon Brown and Chancellor Alastair Daring have been able to hold on, ensuring some level of continuity for the near term. The Sterling has been under significant selling pressure as of late and its future depends on domestic political developments, as much as macro trading themes. The GBP corrective setback from 1.6660 is now pressuring the 1.5880 key support. A break will then have traders focused on 1.5519 (38% fib). And as a final note, ECB and European Union are both watching the situation in Latvia closely as the devaluation debate continues. While Sweden should have the largest direct exposure, and EU countries have attempted to differentiate their own economies there is still a significant concern over contagion risk in the region. With the European Parliament elections out of the way (weakened centre-right coalition) Latvia will need to deliver its fiscal austerity measures for the IMF / EU. In the short term it should calm Sweden’s nerves (expect continued pressure on the SEK) but unlikely to end speculation surrounding the potential exit strategies from the current peg.