The US dollar has appreciated in recent weeks, as overnight index swaps signal that traders expect the Federal Reserve to raise rates by 75 basis points over the course of the next eight FOMC meetings. However, the next release of non-farm payrolls is expected to reveal job losses for the seventh consecutive month while the US unemployment rate is anticipated to hit a 4-year high of 5.6 percent. What are the chances that non-farm payrolls will prove to be even worse than forecasted, and more importantly, how will this impact the US dollar?

What is the Market Expecting for July Non-Farm Payrolls?

Change in Non-Farm Payrolls: -75k Forecast, -62k Previous
Unemployment Rate: 5.6% Forecast, 5.5% Previous
Change in Manufacturing Payrolls: -40k Forecast, -33k Previous
Average Hourly Earnings: 3.4% Forecast, 3.4% Previous
Average Weekly Hours: 33.7 Forecast, 33.7 Previous

Of the 79 economists polled by Bloomberg, the most optimistic forecast is by First Trust Advisors, which calls for a drop of 10k jobs. The most pessimistic is, once again, ING Financial Markets who is calling for job loss of -150k. All of these economists expect a negative print, but the range of estimates is extremely wide which means that traders should expect sharp volatility in the US dollar and the financial markets in general on the back of the non-farm payrolls release.

In order to determine the strength of non-farm payrolls, we typically look at 10 pieces of data that we call the leading indicators for non-farm payrolls. Four out of the ten releases point to greater job losses, putting the odds in favor of a weak non-farm payrolls reading in line with expectations. More specifically, the four-week moving average of initial jobless claims increased to a new 5-year high while continuing claims jumped 6 percent to 3.3 million. On the other hand, consumer confidence has improved somewhat with the pullback in oil prices from record highs, while the ADP employment report unexpectedly showed an increase in hiring. However, we are missing three of the leading indicators we normally watch – ISM Manufacturing, ISM Services, and Challenger job cuts – as they will not hit the wires until later on Friday and next week.

Arguments for Stronger Non-Farm Payrolls

1. ADP Employment Report Unexpectedly Rises 9k Vs. Expectations of -60k
2. Work Stoppages Fall To Zero As No New Strikes Are Reported
3. U of M, Conference Board Consumer Confidence Surprisingly Improves

Arguments for Weaker Non-Farm Payrolls

1. Initial Jobless Claims 4-Week Moving Average Jumps To New 5-Year High
2. Continuing Claims Jump 6% to 3.3 Million
3. Monster.com Index Drops 14% in July From A Year Ago
4. Help Wanted Online Index Declines For 5th Consecutive Month

Will May Non-Farm Payrolls be Better or Worse than June?

The majority of the leading indicators for non-farm payrolls indicate that July was a month of job losses, but there is an unusual amount of uncertainty surrounding this particular release. First of all, two of the key indicators that we normally utilize and are typically the most consistent – ISM Manufacturing and ISM Services – will not be released until after the non-farm payrolls announcement on Friday morning. As a result, our view of employment conditions in those two sectors is a bit blurred.

Nevertheless, though less-reliable, the ADP employment report unexpectedly reflected net increase of 9,000 workers thanks to hiring by small firms and in the services sector, which may help to alleviate some of the weight of job losses amongst manufacturers. Meanwhile, separate consumer confidence surveys by the University of Michigan and the Conference Board surprisingly improved during July. However, a deeper look into the Conference Board report shows that sentiment on the labor markets has steadily deteriorated, with more Americans saying that jobs are harder to get. As a result, despite the lack of more dependable leading indicators for non-farm payrolls, the odds are clearly skewed in favor for yet another round of gloomy employment data.

Could Non-Farm Payrolls Drop by 100k?

The US non-farm payrolls report is one of the most critical releases for the US dollar, not only because it is market-moving, but also because it can help us gauge the broad status of the economy. Despite the fact that GDP rose 1.9 percent in Q2, up from 0.9 percent in Q1, it is far too early to say that the US economy has successfully avoided a recession. A “recession” does not necessarily mean that GDP falls negative, as the National Bureau of Economic Research (NBER) defines it as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” It could easily be argued that the slump in US GDP from 4.8 percent during Q3 2007 down to -0.2 percent in Q4 2007 and 0.9 percent in Q1 2008 represents a “significant decline.” Furthermore, these figures are often revised, as the -0.2 percent reading in Q4 was initially reported at 0.6 percent. Consequently, this advanced reading of Q2 GDP is by no means the final word on economic growth.

Over the past 3 decades, the US economy has gone through 3 recessions, according to NBER. In each of those 3 recessions, there was a string of job losses that lasted for a minimum of 10 months. Thus far, non-farm payrolls have fallen negative for the past 6 months, and the July report is anticipated to bring this tally up to 7. Some argue that the current downturn in growth could be more severe than the recession in the early 2000s due to the triple blow of a housing crisis, credit crunch and skyrocketing commodity prices. As if this weren’t enough, the odds are in favor of more severe job losses in coming months because in each of the past 3 recessions, the largest single month job loss was more than 300k! In this context, a 100k drop over the next few months is not only possible, but probable.

Trading the Non-Farm Payrolls Release

Very few economic indicators are as exciting to trade as the release of non-farm payrolls for the US economy. Indeed, the change in non-farm payrolls for the month of July could determine both the outlook of Federal Reserve monetary policy as well as the fate of the US dollar for the second half of 2008. Currently, the chances of the Federal Reserve leaving rates unchanged at the August meeting are above 93 percent. Yet, the dollar has been rebounding in the days leading up to the non-farm payrolls report and if this important economic indicator surprises to the upside we may see a sharp appreciation of the US dollar against all major currencies. In fact, according to overnight index swaps, which measure interest rate expectations for the next twelve months, traders expect the Federal Reserve to increase rates by 75 bps over the next eight FOMC meetings. Higher interest rates could make the US dollar more attractive to foreign investors and the higher level of demand for assets denominated in dollars could accelerate gains in the USD/JPY and losses in the EUR/USD.

Jamie Saettele is a Technical Currency Analyst for FXCM.