FOREX EUROPE UPDATE - USD

The dollar traded slightly firmer overnight, strengthening against the EUR in a range of 1.3165-1.3189 and holding steady against the JPY in a range of 117.48-117.83.

Equity markets broadly sold off for the third consecutive day yesterday on Thursday as risk aversion continues gain the upper hand globally. Although the dollar has managed to regain some footing over the past 48 hours, we see a strong likelihood of further position unwinding in carry trades as risk-reduction may continue in the short term. Wall Street managed to minimise losses yesterday after some stronger data tempered investor angst.

However, with the VIX remaining elevated at 15.82, sharp downward swings in equity sentiment remains a key risk downside to the dollar, as displayed by yesterday's dollar fall after the Dow Jones opened sharply lower. On the data front, manufacturing ISM for February rose to 52.3, higher than market expectations of 50 and up from 49.3 in January.

Core PCE prices rose 0.3% m/m, and personal income also came in strong at 1.0%. Given markets continue to worry the US housing slump may translate into broader weakness in US economic performance, better household income and consumption indicators will continue to go a long way towards allaying such fears.

However, jobless claims were also higher, up by 7k to 338k in the week ended Feb 24 and on balance US 2-year Treasury yields fell by a further 3bp.

Fed Funds futures are pricing in a full cut by August, though we continue to expect weakening sentiment on the US economy to push the Fed in cutting interest rates by the end of Q2 this year.

The labour market is showing signs of strain, and our economists have already lowered forecasts for the rise in February payrolls to 50k from 75k, and the unemployment rate may rise for a second consecutive month. The outlook for the US dollar during this period of risk reduction is uncertain, as many investors point to last May/June when the US dollar rallied on risk reduction and in general US investors have been heavy buyers of foreign equity markets.

However, this time around, Fed expectations are moving lower rather than higher, which is putting downward pressure on the dollar.

Ahead today, we expect further weakening in the Michigan Sentiment index to 92.5 (cons. 93.5), while Fed chairman Bernanke is scheduled to speak on "Gobalisation and Monetary Policy" after the market close.