Will The Fed React To Friday's Strong Payrolls?

The Federal Reserve has not been shy about letting the market know that their top priority is reducing unemployment. Based on Friday's labor market report, they are on the right course as ultra easy monetary policy helped to drive the unemployment rate down to its lowest level since December 2008. But is the Fed's work done? NO and that's the way investors need to think as we head into next week's FOMC meeting. The Fed will be meeting for the last time this year and in additional to a monetary policy decision, the latest economic forecasts will be shared and Bernanke will hold a press conference. As long as the unemployment rate remains above 7%, the Fed won't be satisfied, particularly given the lack of progress on the Fiscal Cliff and the looming threat that it poses to the U.S. economy. According to House Speaker Boehner, there still has been no progress on budget negotiations. Therefore we expect the Fed to push forward with easy monetary policy and announce fresh measures to replace Operation Twist, which ends this year.

Nonetheless, there is no question that today's non-farm payrolls report was exceptionally strong. Unfortunately the U.S. dollar and U.S. equities did not receive a major boost from the report that American companies added 146k jobs in the month of November, exceeding estimates of the most optimistic analysts on Wall Street. Between Hurricane Sandy and Fiscal Cliff concerns, the market was looking for an addition of only 85k jobs. However the Bureau of Labor Statistics saw no substantial impact from the storm and retailers added more workers ahead of the holiday shopping season. The icing on the cake was the unemployment rate, which dropped to 7.7%, its lowest level since December 2008. The closely watched U6 underemployment rate also fell to 14.4% from 14.6% while average hourly earnings increased by 0.2%.

The positive surprise in both the establishment and household surveys led investors to overlook the 33k downward revision to October payrolls and the 350k contraction in the workforce. With Friday's hot labor market report, there will be no need for investors to look past Sandy's effects even if the storm's impact end up being delayed or seen in future revisions. What is important right now is that the labor market is on firmer footing going into next week's FOMC meeting. The real question is whether the strong non-farm payrolls report will stop the Fed from replacing Operation Twist with additional Treasury purchases and as we noted earlier, we don't believe that it their plans have chanegd. The Fed's concerns about the labor market runs deep and with consumer confidence plunging in December according to the University of Michigan and the Fiscal Cliff in the background, they won't want to risk leaving the economy with even less stimulus going into the New Year. It will be a busy week in the forex market with retail sales, trade and inflation numbers also scheduled for release.

EUR: Hit By Weaker German Growth Forecasts
While the euro ended the day slightly lower against the U.S. dollar, a quick look at the charts will reveal a sharp intraday reversal. Better than expected U.S. labor market numbers helped the euro recover but with only a limited rally in U.S. equities, EUR/USD was unable to turn higher. Part of the reason was because the German central bank slashed its growth forecasts. Both the ECB and Germany's Finance Minister previously warned that the slowdown is hitting the region's largest economy and on friday the Bundesbank released its official forecasts. The Germans now expect their economy to grow by 0.7% in 2012, down from a prior forecast of 1.0% and 0.4% in 2013, down from 1.6%. The 2013 revision was extremely large and shows just how much of a toll the government expects austerity measures inside and outside of Germany to have on their economy. As our colleague Boris Schlossberg noted, The anemic rate of growth indicates that the recession that has been plaguing the periphery economies for more than two years is now making its way to the core. BUBA noted that its lower forecast was due to the uncertainties revolving around the EZ crisis, but stated that it expects Germany to return to the growth path soon. Nevertheless it stated that the balance of risk is skewed to the downside and the glum assessment helped to push the euro lower. The deterioration in the German manufacturing sector also accelerated with industrial production falling for the third straight month by 2.6%. Looking ahead, flash PMIs are due for release next week along with the German ZEW survey. EU Finance Ministers will also be holding meetings ahead of the EU Leaders Summit in Brussels on Thursday and Friday.

GBP: Shrugs Off Big Miss In Industrial Production
The British pound may have ended the day unchanged against the U.S. dollar but this lack of movement from yesterday's levels masks a strong intraday recovery. Sterling trended lower at the start of the European trading session with the selling gaining momentum after the industrial production numbers. U.K. manufacturing and industrial production fell sharply in the month October with manufacturing IP dropping by the largest amount in four months. Economists had initially been looking for a recovery after severe weakness in September but weak growth in Europe, decline in mining, oil and gas production along with softer demand for food and alcohol drove manufacturing activity lower. The GBP/USD remained weak after the U.S. nonfarm payrolls report but started to recover into the European close. By the end of the North American trading session, it was unchanged against the greenback This had everything to do with a payroll driven recovery in risk. According to the National Institute of Economic and Social Research, the U.K. economy expanded by 0.1% in October and November which is consistent with the central bank's forecast for slow growth. Inflation expectations are on the rise however according to the BoE/GfK survey, which could reduce the willingness of the BoE to ease again in the near future. The most important piece of U.K. data next week will be the country's labor market report. Bank of England Governor King is also scheduled to speak on Monday and we will be looking for any comments on the economy or monetary policy.

CAD: Hits One-Month High vs. USD On Sharp Improvement In Job Growth
The Canadian dollar traded higher against all the major currencies on the back of much stronger than expected employment numbers. More than 59k jobs were created in the month November, driving the unemployment rate down to an eight-month low of 7.2%. Earlier this week, the Bank of Canada decided to maintain their hawkish monetary policy stance and many investors including us questioned their thinking because of weak manufacturing activity, growth and retail demand. Their decision was vindicated, Friday, by the solid labor-market report. Nearly all of the job growth was in full time employment, which is exactly what the central bank wants to see and this should pave the way for a recovery in demand going forward. Solid job growth in the U.S. and Canada should fuel further gains in the Canadian dollar with 98 cents being the next level of support for USD/CAD. The Australian and New Zealand dollars on the other hand ended the day unchanged. Australia's trade deficit increased in the month of October from -1420M to -2088M but the deterioration did not have a substantial drag on the AUD because it was better than expected and offset by a mild improvement in the construction PMI index. It has been an extremely busy week for the three commodity currencies but things will be much quieter in the coming week with the only major market moving data coming out of China.

JPY: Quake-Related Rally To Fade
The Japanese Yen strengthened against all of the major currencies with the exception of the CAD. Japan experienced its largest earthquake since March 2011 in the same region that was hit last year. As we saw in 2011, the Yen rallied on the back of concern that any earthquake damage would require lead to Japanese corporations/ Tremors were felt in Tokyo but thankfully no major damage was caused and Tsunami warnings have been lifted. While USD/JPY recovered from its initial decline, other major currencies still gave up their gains. The only pieces of economic data released out of Japan last night were the leading and coincident indices. The leading index increased more than expected but coincident index fell for the second month in a row. While Japan has a tremendous amount of economic data on the calendar next week, the focus will be on the upcoming elections. Pushing for easier monetary policy and aggressive asset purchases by the BoJ has been one of LDP leader Shinzo Abe's main campaign promises and if the polls next week show him gaining majority, the Yen could come under renewed selling pressure.

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