U.S. DOLLAR: GAME PLAN FOR PAYROLLS
The U.S. dollar traded higher against all of the major currencies today. This universal demand for the greenback suggests that the dollar’s rally is fueled less by risk aversion and more by a reduction of short dollar exposure ahead of the non-farm payrolls report. We tend to see profit taking and hesitation the day before the notoriously volatile economic release as currency traders wait for the outcome before deciding what to do next. The degree of job losses will determine whether the dollar continues to fall and the recovery trade moves ahead or give overly optimistic traders a reality check.
Game Plan for Payrolls
Although we always tell currency traders to avoid trading payrolls because of the sharp knee jerk reactions and corresponding reversals, for those traders who insist on trading payrolls, it is important to have a game plan. In our Non-Farm Payrolls Preview, we talked about how the market’s initial reaction to the release rarely lasts for the rest of the day. Instead, there is usually an abundance of volatility in the 30 to 60 minutes after t non-farm payrolls and only after that will we see the real reaction in the EUR/USD which can then last for the rest of the trading day. It pays to wait because until the volatility settled because after the last 7 non-farm payrolls report, the trend that finally emerged became a move that was usually in excess of 150 pips. You also don’t have to guess what non-farm payrolls may be and how the market could react to it because by that time it would already be released. Yet for those traders that insist on positioning ahead of or immediately after the NFP report, it is important to know the “key levels.” The consensus forecast is for payrolls to decline by 325k, but the whisper number is closer to -200k. This means that the market is very optimistic and therefore it won’t take much to surprise or disappoint. The levels to watch are -250k and -400k. If payrolls decline by 250k or less, it will be very positive for risk which means a strong rally in the dollar against the Yen but weakness against higher yielding currencies such as the euro and Australian dollar. If payrolls decline by 400k or more, traders could expect a wave of risk aversion that could drive the dollar lower against the Japanese Yen but higher against the riskier currencies. Anything in between should elicit only a modest reaction in the direction of the surprise.
Which Way Could Payroll Sway?
In terms of how non-farm payrolls may fare, even though we believe that job losses moderated, the odds favor a disappointment. The labor market has been the Achilles heel of the U.S. economy for the past year. Since January 2008, the Bureau of Labor Statistics has reported back to back job losses. July is expected to mark the 19th consecutive month of negative job growth. It is encouraging that job losses are off their peak of -741k but the unemployment has grown from 4.9 percent in January 2008 to 9.5 percent in June. By the end of the year, the unemployment rate could break 10 percent. Yet economists across Wall Street believe that the number of job losses last month could easily have been less than 300k and possibly even less than 200k. The primary reason for this optimism is because weekly jobless claims are well off their highs. Less and less people have been filing for unemployment benefits which would suggest that fewer people lost their jobs in the month June. However, there are plenty of reasons why job losses could be closer to 350k and 400k. We always look at the employment component of service sector ISM as a leading indicator for non-farm payrolls. Over the past 10 years, the index has had an unbelievably strong 87 percent correlation with non-farm payrolls as shown in the chart below. Therefore the drop in the index suggests that the NFPs could be closer to the lower end of the forecasts. Consumer confidence also deteriorated last month while strike activity increased.
Retail Sales Continue to Decline
Although Goldman Sachs’ Abby Joseph Cohen has declared that the new equity bull market has started, weak consumer spending and growing unemployment means that at best, currency traders should be cautiously optimistic. The jobs report tomorrow will show that unemployment continues to rise and until consumers start getting jobs, they won’t be interested in spending. According to the International Council of Shopping Centers, July marked the eleventh straight month of lower sales by retailers. Same store sales fell by 5.1 percent compared to 4.9 percent the previous month. Although spending should pick up in August as back to school sales brings in shoppers, overall demand could be weak. Interestingly enough the discounters such as Target, Costco and BJs missed expectations while companies like Gap, Limited Brands, Saks and Nordstrom did better than expected.
EUR/USD: NO PLAN TO INCREASE COVERED BOND PROGRAM
ECB President Trichet has given euro bulls carte blanche to take the EUR/USD higher. The hesitancy that we have seen in the past few days should be short lived as Trichet indicates to the market that the central bank has only purchased 1/8th of the covered bond purchase allocations which is miniscule compared to other central banks. He also indicated that further fiscal stimulus is not warranted, the central bank will counter any threat to price stability and encouraged governments to prepare ambitious fiscal exit strategies. These are the words of a hawkish central banker who has no intention of increasing the size of their EUR60 billion asset purchase program. Interest rates were left unchanged and the only wrinkle in Trichet's more optimistic mood was his comment that the governing council did not discuss whether the current level of interest rates will be the lowest. For the time being, the central bank continues to be comfortable with interest rates at 1 percent. Even though inflation is expected to dip further into negative territory, it should be only temporary. Economic activity is likely to remain weak but the pace of contraction is "clearly" slowing down and this assessment even takes into account the negative impact of the deteriorating labor market. German factory orders were also much stronger than expected which should fuel gains in the industrial production figures due for release tomorrow. Meanwhile the Swiss Franc traded higher against the euro ahead of Switzerland’s employment report. The jobless rate is expected to rise from a seasonally adjusted 3.8 to 3.9 percent.
GBP/USD: BOE SURPRISES WITH LARGER QE PROGRAM
The biggest surprise today was the Bank of England’s decision to boost their Quantitative Easing program by GBP50 billion to GBP175B. Going into the meeting, there was only a minor chance that the central bank would raise their program by the remaining allocation of GBP25 billion. Instead, they tapped the current remittance and asked for another GBP25B from the Chancellor. This aggressive action indicates that the BoE is not playing any games. They want not just any recovery, but a strong one. Despite improvements in economic data, weak credit growth and the potential for additional spare capacity has been major concern. The BoE downplayed the improvements in PMI and instead warned that the recession “appears to have been deeper than previously thought.” Unsurprisingly, this dovish action drove the British pound sharply lower. Next week, the Bank of England will be releasing their Quarterly Inflation Report. By increasing the size of their QE program, the BoE reignited the risk of runaway inflation. It will be interesting to see if the central bank addresses this issue in their Quarterly report. Given today’s action, we expect the pound to extend its losses ahead of next week’s release which will most likely remind us of the BoE’s cautiousness.