Why the Dollar Could Rise on Payrolls

The U.S. dollar traded higher against all of the major currencies ahead of Friday'snon-farm payrolls report. This strength should not catch anyone by surprise after yesterday's strong non-manufacturing ISM release that told us just how well the U.S. labor market and services sector weathered the hurricane season.  What was unexpected was the market's disregard for the data on Wednesday but they finally came to their senses today thanks in part to hawkish comments from Fed Presidents Harker and Williams who pointed to the improvements in the economy as reasons why the Fed needs to continue raising interest rates. The latest string of U.S. economic reports were also stronger with jobless claims falling, the trade deficit narrowing, factory orders increasing and durable goods orders revised higher for August.  Looking ahead, unlike past NFPs, this month's report won't have as much impact on the Federal Reserve's monetary policy plans and the dollar for 2 reasons.

#1 - First the Fed isn't expected to raise interest rates again until December and there are 3 labor market reports between now and then to evaluate. 

#2 - Second this report will be distorted by the hurricanes. After Hurricane Katrina in 2005 the Bureau of Labor Statistics reported an initial loss of -35K jobs but one month later, it was revised to an increase of 67K jobs. So the prospect of revision and distortion means that market participants including the Fed will discount any significant weakness. 

Therefore the initial decline on a soft report should be short lived but if job growth beats expectations and rises by 80K or more, the dollar will rise quickly and aggressively as the data shows only limited setback from the hurricanes. Based on the following leading indicators for NFPs, there's certainly reason to believe that payrolls will surprise to the upside and if that's the case it would reinforce the Fed's hawkishness. Aside from watching the level of job growth, investors also need to pay attention to wage growth and the unemployment rate. If wage growth, which has been subdued for the past 3 month bounces by 0.3% as anticipated, it could offset a soft headline number or exacerbate a positive report.  Investors will be more surprised by strength than weakness and for this reason we believe the dollar will have a greater reaction to strong versus weak payrolls.  If job growth is 70K or higher and wages rise by 0.3% or more, USD/JPY will challenge its September high of 113.25. If job growth is anything less than 50K AND wage growth is 0.2% or less, USD/JPY will sink back down to 112.00 but in that case, the best trade will probably be to buy EUR/USD for a move back to 1.1850.

Arguments in Favor of Stronger Payrolls

1.     Challenger Reports 27% Drop in Layoffs

2.     Employment Component of Services ISM Rises

3.     Employment Component of Manufacturing ISM Rises

4.     Continuing Claims Drop to 1.93M from 1.95M

Arguments in Favor of Weaker Payrolls

1.     ADP Reports 135K Private Payroll Growth vs. 228K Previous

2.     4 Week Average Jobless Claims Rises to 268K from 236K

3.     University of Michigan Consumer Sentiment Index Drops to 95.3 from 97.5

4.     Conference Board Consumer Confidence Index Drops to 119.8 from 120.4

We'll be watching EUR/USD closely after the non-farm payrolls report because today's brief dip to 1.17 was driven primarily by the rising dollar.  Yet the account of the last ECB meeting was also not as hawkish as EUR/USD traders may have hoped for.  According to the report, the central bank had first talked about recalibrating policy in September and they weighed the trade-offs of various scenarios and agreed that regardless of the changes substantial stimulus is still needed.  They also expressed concerns about the volatility and speed of the euro's rise and agreed to monitor exchange rate moves carefully.  All of this suggests that while the central bank is committed to reducing bond purchases, they are not considering a rate hike and will take each move gradually.  While this may explain why some investors are dumping euros, it won't stop the currency from rising if NFPs disappoint.

Sterling also traded sharply lower and actually experienced steeper losses than the euro. Despite relatively hawkish comments from BoE member McCafferty who said slack is likely to disappear quite quickly as CPI is seen to persistently overshoot the target, sterling was hit hard by Brexit concerns and U.S. dollar strength.  Prime Minister May had a disastrous speech yesterday where she was a victim of a prank then fell into a coughing fit. While neither of these are serious offenses, the media and her opponents saw it as a reflection of her weak leadership. A number of Tory MPs also want May to resign according to former minister Ed Vaizey.  Her political troubles have weighed heavily on the currency and with GBP/USD at the cusp of breaking 1.31, everyone is eyeing the next support at 1.3015.

Canadian labor data is also due on Friday and the loonie has fallen sharply ahead of the release. After consolidating for the past 5 trading days, USD/CAD shot higher on the back of a surprisingly weak trade balance report.  Instead of narrowing, the country's trade deficit widened to in the month of August, reinforcing the Bank of Canada's new concerns.  The labor market has been performing well over the past few months despite a large decline in full time jobs in August.  If job growth fails to live up to expectations, we could see USD/CAD shoot up to 1.2750.  Speculators are aggressively short USD/CAD. We've just begun to see the heavy short covering that could occur if more bad news hits the wires. Aside from the labor data, Canada's IVEY PMI report is also due for release. 

For the first time in more than 2 months, the Australian dollar ended the day below 78 cents. In yesterday's note we outlined the reasons why Australian data could disappoint, adding pressure to AUD. Last night we learned that consumer spending fell by -0.6% in the month of August which was significantly weaker than the market's 0.3% forecast.  The trade surplus increased but this improvement failed to helped to help the currency. AUD/USD still has support at 0.7770, the 100-day SMA and whether than holds or breaks hinges entirely on tomorrow's U.S. non-farm payrolls report.  There were no economic reports from New Zealand, but the currency also fell on the back of U.S. dollar strength.