What Will Payrolls Do To USD?

The U.S. dollar is trading lower against most of the major currencies ahead of the all important nonfarm payrolls report. With less than 2 weeks before this year's last Federal Reserve meeting, Friday's release will determine whether the central bank will pull the trigger and reduce asset purchases on December 18th. Given the steep drop in the employment component of non-manufacturing ISM, we are looking for U.S. companies to add between 150k and 175k jobs in the month of November. If NFPs exceed 200k, the dollar should recover Thursday's losses quickly with USD/JPY trading back above 102 easily. However if payrolls rise by less than 125k, the Federal Reserve will almost certainly keep monetary policy steady this month and the expectations of no taper in 2013 should erase even more of the dollar's gains. Handicapping the price action gets far trickier if payrolls rise between 150k and 175k, which is the most likely scenario because arguments could be made for and against an earlier move. Changes in the unemployment rate will also be important. We continue to believe that the Federal Reserve will wait until March of 2014 to reduce its monthly bond buys with a 30% chance that it could also happen in January. The labor market in general is improving and with upside surprises seen in many other economic reports, it should only be a matter of time before the central bank reduces Quantitative Easing.

Every month we look at 8 leading indicators for NFPs to gage how the upcoming release could fare. This month nearly all of the releases point to stronger job growth. From a higher ADP employment change to a 20% drop in job announcements according to Challenger Grey & Christmas, decline in jobless and continuing claims along with a rise in University of Michigan consumer confidence index and the employment of manufacturing ISM, most signs point to a payrolls in excess of 200k. However none of these reports are as reliable as the non-manufacturing ISM in handicapping the directional surprise of NFP. In fact, this release was one of the few that accurately predicted last month's stronger print. In addition, a survey by the Conference Board found consumer confidence declining in November so not everyone feels more optimistic. Furthermore, October's report was unusually strong so the risk of a pullback or downward revision is exceptionally high.

Meanwhile the price action in the dollar Thursday suggests that investors are looking forward to Friday's release and Q4 GDP. While jobless claims fell sharply and U.S. GDP growth was revised higher, the greenback failed to hold onto its initial gains as investors immediately interpreted the rise in inventories to mean that Q4 GDP growth could be even weaker than most economists had anticipated. Q3 GDP was revised up to 3.6% from 2.8% after the largest rise in inventories in 15 years. This increase in inventories reflects expectations for stronger consumer demand but with personal consumption growing at its slowest pace since 2009, consumer appetite remains weak. As for jobless claims, for the second time this year, fewer than 300k claims were filed last week. Economists were looking for claims to rise but instead, it fell to an almost 6-year low of 298k. Even though fewer layoffs may not translate into more hiring, the consistent decline in jobless claims over the last 4 weeks is positive for nonfarm payrolls. However with yesterday's ISM report showing employment growth slowing in the service sector, the dollar's rally has been limited because investors are eyeing these conflicting reports with caution.

Euro Climbs To 1-Month High, ECB Sees No Rush To Ease
The euro climbed to a 1-month high against the U.S. dollar Thursday after ECB President Draghi reassured investors that they are in no rush to ease again. As expected, the European Central Bank and the Bank of England left monetary policy unchanged. The ECB upgraded its GDP forecasts for next year by 0.1%, talked about the positive developments in the economy since the last monetary policy meeting and downplayed the need for negative rates. According to Draghi, the committee only discussed this option briefly and while they are technically ready to take rates below zero, they see no reason to do so now. He also explained that the situation Thursday is fortunately substantially different from when they did LTRO 2 and this implies that there is no urgency to introduce another long term refinancing program when the current one ends. The only problem is that the central bank now expects inflation to remain below their 2% target for the next 2 years. In line with the recent drop in CPI, they revised down their 2013 and 2014 inflation forecasts. Easy monetary policy should support a slow and gradual recovery in the coming year. The bottom line is that the ECB is comfortable with the current level of monetary policy and wants to see how the economy responds to the last rate cut before deciding whether additional action is necessary. With negative rates no longer an imminent threat to the euro, the currency could aim for its yearly highs against the dollar if payrolls surprise to the downside.

CAD: IVEY PMI Details Not As Ugly As Headline, Employment Next
The Canadian, Australian and New Zealand dollars traded higher against the greenback Thursday despite weaker economic data. In Canada, manufacturing activity slowed significantly in the month of November with the IVEY PMI index dropping to 53.7 from 62.8. While economists had anticipated a decline after the past month's sharp rise, the magnitude of the drop was far larger than everyone had expected. The slowdown in activity was caused almost entirely by a contraction in inventories because employment and prices increased. Supplier deliveries only declined slightly so the details of the report were not nearly as discouraging as the headline release. Building permits also jumped 7.4% in October after rising an upwardly revised 4.1% the previous month. Canada's employment repot is due for release Friday and steady job growth is expected. An increase in the unemployment rate and decline in jobs would be needed to drive USD/CAD above 1.07. No major economic reports were released from New Zealand but Australia's trade balance widened significantly in the month of October. AUD/USD shrugged off the news but the drop in exports and imports highlights the pockets of weakness in Australia's economy.

GBP: Hit By Demand For EUR/GBP
Demand for EUR/GBP drove sterling lower against all of the major currencies. As expected the Bank of England left monetary policy unchanged and their decision had very little impact on the pound. However comments from ECB President Draghi triggered the largest one day rally in EUR/GBP since May. Although we have seen more improvements than deterioration since the last Boe meeting, the skeptical policymakers on the Monetary Policy Committee are in no rush to express their satisfaction with the data. This sentiment should be echoed in the central bank minutes due in 2 weeks time. In all likelihood, the central bank grew more optimistic but they are a long way from raising interest rates. Even though we have seen improvements in the manufacturing and construction sectors this week, service sector activity slowed with the PMI index dropping to 60 from 62.1. This pullback is not overly concerning because the index hit a 16 year high the month prior. Sterling underperformed Thursday but we continue to see any decline as an opportunity to buy at lower levels because the outlook for stronger growth in 2014 has not changed.

JPY: Investors Rush To Cash In Before Capital Gains Tax Hike
The Japanese Yen held steady or traded higher against all of the major currencies Thursday. The sell-off in USD/JPY along with the drop in U.S. and Japanese stocks kept all of the Yen crosses under pressure. This week alone, the Nikkei has fallen more than 3.5% and appears poised for another 1% in losses. Profit taking before year-end is one of the main reasons for the slide in equities. With capital and income gain taxes expected to be raised from 10% to 20% in the beginning of 2014, many retail investors are rushing to cash in on their profits. The Nikkei has risen 50% this year so profit taking at these levels is not unusual. However even though domestic investors may continue to sell stocks before year end, foreign investors could hunt for bargains because Japanese monetary policy is still expected to drive stocks higher in the coming year. The sell-off in the Nikkei should therefore limited to no more than 5%. We are also looking for the sell-off in USD/JPY to be limited to 100 unless of course nonfarm payrolls are shockingly weak. Meanwhile Japanese investors bought foreign bonds for the fifth consecutive week, which is also not surprising considering that Treasury yields are closing in on 3%.

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