NFP Will Make Or Break The Dollar

Non-Farm Payrolls Will Make or Break the Dollar
The non-farm payrolls report is always an important release for the U.S. dollar but this month in particular, it could make or break the greenback. In January, the U.S. dollar collapsed and officially peaked after the worst NFP report in nearly 3 years. This month investors are hoping for a strong rebound that will restore demand for U.S. assets. Economists are looking for non-farm payrolls to more than double and rise from 74k to 180k. The rise in U.S. stocks, rally in risk currencies and uptick in Treasury yields today suggests that investors are also bracing for a solid report. While we are fairly certain that payrolls will rebound because if they don't, the U.S. economy is in big trouble and the Janet Yellen's credibility will come under serious scrutiny, there's a risk that the increase will fall short of expectations, driving the dollar sharply lower.

Every month we take a look at a number of labor market indicators to help us determine whether NFPs will surprise to the upside or downside. As you can see in the following list, the arguments for a weaker report outweigh a stronger one. We are not looking for job growth to slow in January because last month, these same leading indicators failed to forecast the drop in payroll growth. Yet what the leading indicators suggests is that the risk is to downside for tomorrow's report and if less than 125k jobs were created last month with no major upward revision to the January release, the improvement in risk appetite and recovery in USD/JPY could fade quickly. In fact fewer than 125k jobs could send USD/JPY to fresh 2 month lows below 100.75. If there is a strong rebound that exceeds 200k, USD/JPY could extend to 103.

When it comes to the non-farm payrolls report, the dollar's reaction is not only contingent upon the amount of job growth but also revisions to past reports and most importantly, changes to the unemployment rate. The jobless rate fell rapidly over the past 2 months and if that pace continues, it may have dropped to the Federal Reserve's 6.5% threshold back in January. We don't think it has but cannot rule out the possibility. Regardless, if the unemployment rate drops even 0.1%, we expect a sharp rise in the dollar because it would necessitate some of type response from Yellen in March. Most policymakers don't think that lowering the threshold is the right decision and any action short of that may disappoint dollar bears.

Non-Farm Payrolls Preview

Arguments for Stronger Payrolls

1. Employment Component of Non-Manufacturing ISM Hits Strongest Level Since November 2010
2. Rise in Conference Board Consumer Confidence Index
3. 4 Week Average Jobless Claims Drop to 334k from 358k

Arguments for Weaker Payrolls

1. Drop in Employment Component of Manufacturing ISM
2. ADP Employment Change Falls to 175K in Jan vs. 227K in Dec
3. Challenger Job Cuts Rise 11.6%
4. Drop in University of Michigan Consumer Sentiment
5. Continuing Claims Rise to 2.96M from 2.86M

ECB: What Did Draghi Say to Send EUR to 1.36?
As usual, the euro did not react to the European Central Bank's monetary policy decision until ECB President Mario Draghi started his press conference. The currency trended higher throughout Draghi's speech, taking out 1.35 and 1.36 levels in the process. Although many investors may wonder what Draghi said to drive the currency up nearly 1 cent, it was what he didn't say that set off the rally in the currency. The ECB President did not express any major concerns about the crisis in emerging markets, increased worries about inflation, monetary conditions or the economic outlook. His comments were virtually unchanged from January and given the recent pressure on the EUR/USD, the lack of increased concerns about growth or inflation disappointed the bears and drove the currency pair sharply higher. Lets be clear, the ECB maintains a bias to ease. Without any ambiguity, Mario Draghi said they would take further decisive action if needed. He indicated that rates would remain low for an extended period of time because of the prolonged period of low inflation and downside risks to growth. However the difference between this month and last month is that Draghi acknowledged the encouraging signs in the recovery, pickup in consumer demand, rise in confidence and stable savings rates. In January, he ignored all of the improvements in German data and spent most of his speech taking about low inflation.

Draghi's slightly more positive outlook on the economy single handedly drove EUR/USD above 1.36 even as he warned that the central bank needs to remain extremely cautious because the recovery is fragile and uneven. As for the future of monetary policy, Mario Draghi reiterated that worsening inflation or unwarranted market tightening as triggers for additional monetary actions. However the recent signs of recovery reduce part of their concerns about lower inflation and money market rates have been stable. At the end of the day, the ECB is in no rush to increase stimulus and did not move closer to easing this month, which is enough for EUR/USD traders to bid up the currency. If EUR/USD holds above 1.36, the next stop will be 1.37.

CAD: Canada Has Jobs Numbers Too!
Thanks to the improvement in risk appetite, the Canadian, Australian and New Zealand dollars traded higher against the greenback. Like the U.S., Canada will be releasing its labor market report tomorrow but this usually gets lost in the shuffle amidst the excitement around non-farm payrolls. Nonetheless, there have been some wild swings in Canada's employment report in recent months including a significantly large decline in job growth at the end of last year. A 20k increased in jobs is expected for January after the 44k decline the previous month. The unemployment rate is also expected to decline after spiking in December. As indicated by today's wider trade deficit, December was a very tough month for Canada and the IVEY PMI index also dipped to a 4.5 year low that month. 2014 however seem to be off to a better start with IVEY PMI rising back to 56.8 from 46.3. However the employment component of the report continued to fall, which is not a good sign for the labor market. USD/CAD has been consolidating near its 4-year highs for the past week and a strong jobs number would accelerate the losses and trigger additional profit taking. If the rebound in job growth falls short of expectations, USD/CAD could spike to new highs. Back in January, when U.S. and Canada's jobs report both surprised to the downside, USD/CAD rose approximately 60 pips indicating that for this pair, the Canadian jobs number is more influential. Meanwhile the Australian dollar benefitted from an increase in retail sales and improvement in trade activity. A surge in iron-ore exports turned Australia's trade deficit into a surplus in November and December. This is significant as it ends 22 consecutive monthly trade deficits and gives A$ traders an even stronger reason to unwind their short positions. It should be a busy night for the Australian dollar with the PMI Construction index scheduled for release along with the RBA's Quarterly Monetary Policy Statement. HSBC will also release its final Chinese services PMI index.

GBP: No Changes from BoE, What is Next
The British pound strengthened against the U.S. dollar but weakened against the euro today. Sterling benefitted from the improvement in risk appetite and stronger economic data. According to Halifax, house prices rose 1.1% in January, slightly more than the market's 1.0% forecast. As most economists and investors had expected, the Bank of England left monetary policy unchanged. Major changes in monetary policy is generally telegraphed in the central bank's Quarterly Inflation Report, which is scheduled for release next week. The report will give us a much better assessment of how quickly the central bank plans to raise rates. With the U.K. unemployment rate dropping within 0.1% of the BoE's 7% threshold last month, they will be hard pressed to address what would happen if the target is reached. There's no question that the central bank will downplay the significance of this threshold by saying that it is not a trigger for a rate cut but they could choose to lower the threshold which would send a very strong signal to the market. Based on the recent decline in the manufacturing and service sector PMI indices, the BoE may feel compelled to do so but we'll have to wait until next week for more clarity. Before the market shifts its focus to the U.S. employment report, the U.K. will release its trade balance and industrial production numbers. Based on the second consecutive monthly decline in the PMI manufacturing index, the odds favor a downside surprise in tomorrow's U.K. economic reports.

Yen Crosses Hampered by Market Uncertainty
Led by the rally in USD/JPY, all of the Japanese Yen crosses performed well today with the largest gains seen in AUD/JPY and NZD/JPY. The near term outlook for the Yen will hinge entirely on the move in U.S. bond yields and overall risk appetite post NFPs. In Japan, investors sold the largest amount of foreign stocks since October 2013 last week while foreign investors sold the largest amount of Japanese stocks since June 2010. This shift in positioning reflects the global liquidation of risk assets at the end of January that was caused by the uncertainty in emerging markets. Based on the latest comment from Bank of Japan members Nakaso and Iwata, the central bank remains committed to their 2% inflation target. Nakaso said Japan is making steady progress towards that goal and will make adjustments if needed to ensure Japan meets the target. Iwata touched on what happens after the goal is reached. He said the central bank "won't suddenly end easy policy until 2% inflation is achieved in a stable manner." Iwata was not concerned about the economy losing momentum after the consumption tax is increased and even though "export lacking momentum now," it is "likely to rise moderately as overseas growth picks up.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.