US non-farm payrolls fell by 35,000 in September from a revised 211,000 reading in August, while the unemployment rate jumped to 5.1% from 4.9% and average hourly earnings rose to 0.2% from 0.1%. The revisions for July and August payrolls netted an upward revision of 115,000, while the unemployment rate was the highest since May.

The impact of Hurricanes Rita and Katrina was explicit throughput the September report. Services industries lost 36K jobs, marking their first monthly decline since March 2003, and compared to the year's monthly average of 187K. Retail industries lost 88K compared to the year's monthly average of 24K, while leisure and hospitality employment lost 80K jobs--the first drop since April 2003 - compared to the year's monthly average of 31K.

Industries with notable strengthening were professional and business services industries, which created 52K jobs and education/health employment which netted 49K. The nationwide strength in construction sector reflected a robust 23K increase.

The innate uncertainty of the payrolls report is expected to be magnified in the months to come as markets mull the extent of Hurricane oriented job losses.

Dollar Reaction

The dollar is staging a steady rally after the less than expected decline in payrolls, retracing a 1/3 of Thursday's 2.5 cent plunge against the euro, and erasing 90% of Thursday's losses against the yen.

FX players are still contemplating the factors behind Thursday's USD plunge , which was the biggest one day drop against the euro in 3 years. The dollar sell-off, which started in Wednesday's Asian trading, a few hours following the higher than expected drop in the September services ISM. The dollar drop then intensified in Thursday European/US trade ahead of the ECB decision and after the jobless claims.

Also of worth noting, is that it took the euro a massive one-day 2.5 cent for the currency to avoid posting its fifth weekly loss against the dollar - which would have been be the longest of such weekly losses since July 2000.

The timing of Thursday's dollar loss also reflects technical forces at play , such as the 3-month high of 90.45 in the dollar index, the 200-week moving average of 114.49 in USDJPY and the year's low of $1.1866 in EURUSD. Fundamentally speaking, one asks how can players rush into selling the dollar - albeit at these attractive technical levels - in the face of the Fed's bolstering anti-inflation rhetoric? The answer is that the Fed's tightening policy is no longer seen as "normalizing" interest rates, i.e. taking fed funds back to neutral, rather is aimed at tackling inflation at the risk of slowing an already retreating consumer and endangering growth.

Negative vs. Positive Fed Tightening

The Fed can be likened to a soccer referee or a basketball official. The less noticeable it is, the more likely participants are playing by the rules. When the referee increases his interventions on the field, it is a sign that he may be losing control over unruly players. In the case of the Fed, once inflation shows itself in each and every indicator (Philly Fed, Chicago PMI, ISMs, Core PCE), the Fed shifts its focus from that of normalizing interest rates to chasing inflation. Markets also view this as a shift from "positive tightening" (aimed at redressing the real cost of money towards its long term average) to "negative tightening" whose goal is principally that of chasing inflation at the risk of hurting growth.

The fact that Dallas Fed Chief Richard Fisher reiterated this week his preoccupation with core inflation being closer to the upper end of the Fed's tolerance zone was a major wake up call to bond traders considering his "baseball" references in June which conveyed his certainty that the Fed would end its tightening cycle in June. Those remarks were unusually forthright for an FOMC member since it is rare for FOMC officials to state what and when the Fed should do.

Fisher expressed concern with the government's "fiscal predicament", indicating he would never vote to monetize the "US fiscal profligacy" also reflects the Fed's aggressive anti-inflation stance. Thus, unlike during the oil crisis of the early 1970s when the central bank slashed interest rates by half to relieve the contractionary effects of rising energy prices, the Fed today is set on combating the inflationary threats of higher energy. Most notably, Kansas Fed Chief Thomas Hoenig said higher prices were causing slower personal spending, which was a worry. But Hoening went as far as acknowledging the potential contractionary impact of higher energy prices, which in fact could be exasperated by the Fed's overt tightening.

FX Cannot Ignore Stocks, Bonds

The Fed's negative tightening is also noted in the ensuing stock market sell-off as equities drop across the board. The S&P500 has fallen nearly 4% in 3 days breaching below the 200 day MA for the first time in 5 months. Clearly, stocks traders are growing anxious over the extent of the central bank's tightening in a high an environment of record high energy prices. Fixed income traders are also growing restless, if not lacking confidence in the Fed's anti-inflation fight. The fact that the 10-year yield remained near its 2-month high of 4.40% when the services ISM was pummeled to a 2-1/2 year low by rising oil prices implies that traders are largely concerned by the report's prices paid index which soared to its highest level of all time. Thus, with stock traders worried about growth and bond traders lacking confidence on inflation, the US currency is apt for a reassessment by yield chasers.

Looking ahead, we expect EURUSD to weaken to as low as $1.1750s before closing the month near the $1.18 figure. The increasingly hawkish statements spanning the FOMC underline the central bank's commitment to increase interest rates by at least 50 bps in the next 3 months. Despite some semblance of order in the German electoral arena and increased hawkishness in the ECB, the Fed-yield picture overwhelms the majority of other issues for the month.

October 2005 FX Forecast