2 Main Forces At Work: ECB And U.S. Jobs

There are two main forces at work as the week winds down. The first is the ECB's confirmation of its asset purchases. This has renewed the rally in European peripheral bond markets and re-accelerated the euro's slide. The second is the US monthly employment report, which follows a string of relatively soft economic data.

The euro bounced initially on ECB President Draghi's remarks, reaching almost $1.1115 before being sold off briefly through $1.10. Follow through selling today has seen it fall towards $1.0960. The sell-off is dragging down other European currencies, including sterling, where the May election polls highlight the likelihood of a coalition government. It is difficult to find any meaningful chart support, but there is some talk of the $1.0750 area as the next target.

In January, the euro slid 6.6% against the dollar. In February, it fell less than 1%. Some participants are seeing the loss of downside momentum as a sign that a significant bottom was at hand. Given the underlying divergence of monetary policy, which strikes us as unprecedented, we suspect the dollar bull market/euro bear market is a little more than half way to where it is ultimately going in this cycle. The euro peaked last May near $1.40. It has fallen 30 cents. We anticipate it falling toward euro's record lows set in 2000 near $0.8200 and have suggested an $0.8500 target by the end of next year. This is not simply about fair value. It is understanding that such powerful moves in the foreign exchange market most often do not end before any reasonable model of fair value is overshot.

The ECB's new forecasts seem optimistic. Growth this year is now expected to be 1.5%, up from 1.0% it estimated four months ago and next year's GDP is seen at 1.9%. Even its inflation forecast seems optimistic and largely hinges on its oil assumption, which is simply taken from the futures curve. Zero on average this year means a sharp increase at the end of the year. Next year's forecast is for harmonized CPI to reach 1.5% and then 1.8% in 2017. This implies the ECB anticipates reaching its target then which is close to but less than 2%.

We were also struck by Draghi's implicit claim that the increased asset purchase plan has been successful because investors have already driven down yields. He also seemed to be too dismissive of concerns that European banks, pensions funds, and insurers may be reluctant to sell to the ECB. Draghi noted that nearly half of the euro area bonds are held by investors outside EMU. The implication of this is that the ECB's bond buying program is likely to be particularly euro negative.

One thing that could stall the euro's decline ahead of the weekend is a disappointing US employment report. The Bloomberg consensus is for a 235k increase after 257k in January. Most of the recent US data has surprised on the downside. The US has not reported a sub-200k non-farm payroll report since last February. We think this is the risk today. Job growth in last November and December had accelerated--750k net new jobs were created in those two months. After above trend growth, we recognize the risk of payback now. This is especially true given the weather considerations, the labor disputes, and the higher weekly initial jobless claims.

Although the market may react to the headline, the details may be more constructive. In particular, average hourly earnings are expected to rise 0.2% after a sharp 0.5% increase in January. The unemployment rate is expected to slip back to 5.5%. However, the worst thing for dollar bulls, and late euro shorts would be a disappointing headline below 200k and weakness in hourly earnings.

However, the Fed's leadership recognizes the volatility of high frequency data and weather distortions. Last year the US economy contracted in Q1 and still Yellen led the Fed's tapering operation and was not distracted. A weak jobs report might spur some market participants into thinking that the Fed will retain its patience forward guidance when it meets after next week. We continue to think that the most likely scenario is that it jettisoned and that a rate hike in June/September remains the most likely scenario even with a weak report today.