Friday's payroll data has certainly punctured short-term dollar optimism, but a measured Fed tapering remains likely given the overall data flow. Market expectations have already adjusted which will lessen the scope for further dollar losses, especially with speculative positioning still long Euros. Given dovish rhetoric from ECB President Draghi, the Euro will find it very difficult to secure further gains. There is also still a strong case to expect the Euro to weaken sharply in the medium term on underlying eurozone stresses. Even if this is not the case, the overall yield structure suggests a move at least back to the 1.30-1.32 trading range and EUR/USD is a solid sell on approach to 1.33.
The main damage from the US employment data came from the downward revision to July's estimate. This will work both ways as the Fed will also be wary of potential upward revisions to recent data. In this context, the FOMC will look at a much wider set of economic and financial indicators.
The comments from San Francisco Fed President Williams are potentially very significant, especially as FOMC will now be very reluctant to comment on policy ahead of the September 17-18 meeting. He commented that the economy is getting closer to a substantial jobs-market improvement and that the August data was consistent with the outlook for a gradual improvement.
In essence, the Fed has already committed itself to a tapering move and will be extremely reluctant to reverse course now. A U-turn would result in major damage to longer-term credibility as well as exposing markets to fresh instability when tapering speculation increases again. It is still highly likely that the Fed will push ahead with a reduction in bond purchases as the cost of reversal from here will be higher than any potential benefits.
There is certainly the potential for the size of the tapering to be scaled back due to doubts over the economy, although the ISM data evidence has been much more robust. It is also important to note that ISM releases are a more important leading economic indicator than payroll data which tends to be a lagging indicator. The Fed will look to strengthen forward guidance, but will also be looking to plan for a sequence of tapers to keep expectations in check and curb volatility.
Although the ECB's press conference last Thursday was quickly over-shadowed by the US payroll data, Draghi's underlying message was important. He clearly warned that the ECB would consider taking action to counter any further unwarranted rise in money-market rates. This will put an important potential cap on the Euro's gains even if eurozone risk premiums remain lower.
US two-year yield spreads over German bunds are still significantly more in the dollar's favor than they were at the beginning of August while US 10-year yields remain above 2.90%. The overall yield structure still suggests a 1.30-1.32 EUR/USD range is more appropriate than 1.32-1.34.