By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Investors took profits on their long dollar positions ahead of Friday’s nonfarm payrolls report. The sell-off was motivated by a weak manufacturing ISM number but the stakes are high for Friday’s release and some traders decided to reduce exposure. Federal Reserve officials made it very clear that the decision on a rate rise in September would hinge in large part on the jobs report. If nonfarm payrolls exceed 200K and the unemployment rate holds steady -- or better yet improves -- then expectations for a rate hike this month will spike, sparking a broad-based dollar rally that will take USD/JPY to fresh 1-month highs. If the numbers are strong enough, we could even see 105 USD/JPY. However, if NFP disappoints, we could see a nasty correction in the dollar, particularly after the strong gains that it has seen this month. The steepest decline should be against the British pound and New Zealand dollar -- two currencies that have performed particularly well pre-NFP.
Taking a look at the leading indicators for nonfarm payrolls, there’s no reason to believe that the number will be overwhelmingly strong. We know that Federal Reserve officials are hopeful because they have been talking about the healthy pace of job growth, but the smaller amount of layoffs, rise in jobless claims and mixed confidence readings raises red flags. The increase in ADP employment change was extremely modest and the manufacturing sector continued to shed jobs. Our most reliable leading indicator for nonfarm payrolls is the ISM non-manufacturing report, which will not be released until next week. Even though U.S. policymakers have been adamant about the need for a further rate rise, investors have been very skeptical. They certainly don’t believe that the economy is healthy enough for rates to rise twice this year nor are they convinced that data is strong enough to warrant a hike in 4 weeks. An unambiguously positive report would be needed to convince them otherwise, especially after Thursday’s weak manufacturing ISM that showed activity contracting for the first time since January.
August Leading Indicators
Arguments For Weaker Payrolls
- Challenger Reports -21.8% Drop in Layoffs vs. -57% in previous month
- University of Michigan Consumer Sentiment Index Declines
- 4-Week Jobless Claims Rises Slightly to 263K
- Employment Component of ISM Manufacturing Index Drops to 48.3 vs. 49.4
Arguments For Stronger Payrolls
- ADP Rises to 177K from 171K
- Consumer Confidence Surges to 11 Month High
- Continuing Claims Drop Slightly
Thursday's best-performing currency was the British pound, which soared on the back of surprisingly strong manufacturing activity. Economists had been only looking for a modest increase in the PMI report from 48.2 to 49 but instead the index jumped to 54.4, its strongest level since October 2015. We were clued in to its possible strength by the CBI report but Thursday’s release is a testament to the economy’s resilience to Brexit. Of course, a deeper look reveals that the primary area of strength was in exports, which was lifted by a weaker sterling. Consumer goods also saw healthy demand and new business rose at its quickest rates in a year. According to our colleague Boris Schlossberg, “For now the market is clearly enjoying the UK economic rebound and cable shorts are being squeezed mercilessly” but he warns that while “It’s doubtful this state of “uncertain bliss” will be allowed to remain much longer. The Germans, who ironically enough are suffering the most from Brexit so far, are unlikely to tolerate this state of affairs for much longer and as for the UK government of PM May, the attitude appears to be to proceed with the Brexit despite the opposition of the business sector. Ms. May ruled out the possibility of a Parliamentary vote on Brexit, thus eliminating one of the surest ways to delay the plan.”
Meanwhile EUR/USD took out 1.12 despite weaker economic data. The Eurozone manufacturing PMI index was revised down to 51.7 from 51.8. No changes were made to the German report, which means slower growth in France is to blame. The European Central Bank meets next week and this report along with Wednesday’s softer Eurozone CPI raises concerns for the economic forecasts, which will be released alongside the rate decision. With inflation undershooting their targets, it is realistic for the central bank to reduce its own projections, which could be extremely negative for the currency. However right now, the focus is on U.S. nonfarm payrolls and even though EUR/USD enjoyed a strong rally Thursday, as long as it holds below the 100-day SMA and August 2 high of 1.1234, the downtrend remains intact.
For the second day in a row, USD/CAD was unchanged despite a sharp fall in oil prices. The commodity’s recent decline accelerated after the $45 mark was broken. While there’s been talk of a production freeze by OPEC, high inventories have been keeping prices under pressure. Canada’s trade balance report is also scheduled for release on Friday and while we believe trade activity improved, it may be difficult for CAD to shrug off the decline in oil, particularly with U.S.-Canadian yield spreads moving lower.
The Australian and New Zealand dollars performed extremely well. The Australian dollar’s strength comes despite softer economic data. AiG PMI was reported at 46.9 vs. 56.4 the prior month. Retail sales also missed expectations, coming in flat vs. an expected 0.3% increase. The strength in the Aussie can be attributed to stronger manufacturing PMI numbers for China, Australia’ biggest trading partner. Chinese manufacturing PMI came in as 50.4 vs. 49.9 expected. Chinese non-manufacturing PMI was reported at 53.5 vs. 53.9 expected. Caixin PMI Manufacturing reported a reading of 50.0 vs. 50.1 expected. No economic reports were released from New Zealand, but that did not stop NZD/USD from breaking out to the upside.