This Friday, we are expecting July Non-farm payrolls and now more than ever, the stability of the US economy hinges on the strength of the labor market because non-farm payrolls could easily make or break it for the US dollar. Over the past few weeks, we have heard nothing but bad news out of the US economy including major losses reported by hedge funds and mortgage lenders, blocked withdrawals and the threat of bankruptcies.

Risk aversion has skyrocketed and the world has been pushed into a global credit crunch. The only thing that can bring back optimism and revive carry trades is a report of strong job growth in the month of July. Unfortunately the divergences in the leading indicators for non-farm payrolls make it very difficult to figure out whether non-farm payrolls will be strong or weak. We also typically get service sector ISM before NFPs, but this month, it comes after the release. In an environment where the US economy is becoming increasingly vulnerable, even if the jobless claims figures indicate that companies are not firing, they may not be hiring either. Economists are currently calling for payrolls to increase by 127k, after rising 132k the prior month. Forecasts range from a low of 60k to a high of 178k. The recent rebound in the US stock market and the market’s overall risk appetite suggests that traders may be holding out the hope for a stronger number. Let’s take a look at the possibilities of that scenario:

What US Dollar Traders Should Watch

In order for non-farm payrolls to be dollar positive, we may simply need to see job growth in excess of 110k. The hope is that as long as companies are still hiring, consumer spending could rebound after having fallen 0.9 percent last month. The labor market is the backbone of the US economy and weak job growth poses a big threat to consumer spending. We are already hearing reports of late credit card payments and increased delinquencies. If the labor market buckles as well, retail sales this month could be in serious trouble. The market is already pricing in a 100 percent chance of an interest rate cut by the end of the year. At this moment, the Federal Reserve is still holding onto its hawkish inflation bias because inflationary pressures remain a concern. However if NFP is weak, they may have to recognize what the market has already decided for them, which is the need to consider loosening monetary policy at the end of the year. On the other hand, if payrolls are very strong, we could see a further recovery in both the Dow and carry trades. Also watch for revisions to the June figure because we have seen revisions to prior payroll numbers exacerbate or negate the surprise in the headline number. If both the headline and revised number turns out to be dollar negative however, then market watchers will pounce on the idea of sharply slower consumer spending and growth this quarter.

What is the market expecting for July?

Change in Non-Farm Payrolls: 127k Forecast, 132k Previous
Unemployment Rate: 4.5% Forecast, 4.5% Previous
Change in Manufacturing Payrolls: -15k Forecast, -18k Previous
Average Hourly Earnings: 0.3% Forecast, 0.3% Previous
Average Weekly Hours: 33.9 Forecast, 33.9 Previous

The odds are tilted in favor of a weaker NFP number, but there are solid arguments supporting both stronger and weaker job growth:

Examining the Leading Indicators for Non-Farm Payrolls

Arguments for Below 100k Non-Farm Payrolls

- ADP Employment Falls to 4 Year Low
- Challenger Reports a 15% Increase in Layoffs
- Employment Components of Both Manufacturing ISM and Chicago PMI Fall Sharply
- Monster.com Employment Index Falls 3 Points
- Help Wanted Ads Hit 49 Yr Low

The indicators that correctly forecasted the directional surprise of last month’s stronger than expected non-farm payrolls were the ADP Employment survey, the Challenger layoff report and service sector ISM. We will not have the benefit of the ISM number before NFP on Friday, but the fact that both the ADP and Challenger reports reversed in the month July is one of the main reasons why payroll growth could have fallen below 100,000 last month. The ADP figure is a bit distorting however since they overshot private sector employment for June, which means that the latest drop could be a correction off of that figure. However the overall weakness of the US economy could also be a good reason for companies to slow hiring. In June, help wanted ads in newspapers fell to a 49 year low while online ads also dropped. The manufacturing sector, which has benefited significantly from the weakness of the US dollar could also be seeing more job losses since the employment components of both the national and regional manufacturing surveys deteriorated last month. A weak number would be negative for the US dollar since it pushes the Federal Reserve closer to lowering rates this year. Recent economic data suggests that August will only be a tougher month.

Arguments for Above 140k Non-Farm Payrolls

- Jobless Claims Remain Lowest Since May
- Consumer Confidence Remains High
- Hudson Employment Index Improves

There are also arguments in favor of strong and steady job growth however. The main argument is the fact that the four week moving average of jobless claims dropped from 309k to 305.5k. The last time the average of claims were this low was back in May and that month, 190k jobs were added to US payrolls. We of course don’t expect the same degree of strength, but at least it gives payrolls a strong chance of at least holding the 100,000 level. Furthermore consumer confidence hit a 6 year high in July. According to the report, consumers felt more optimistic about the job market. Those saying that jobs were “hard to get” declined from 20.5 percent to 18.4 percent. Those claiming jobs were “plentiful” increased from 27.6 percent to 30.5 percent. The number of people who expect fewer jobs to be available in the month ahead also decreased to 15.1 percent from 17 percent. It would be counterintuitive for consumers to be so optimistic if the labor market was in trouble, which leads us to believe that job growth could not be that bad.

Conclusion

When watching for the non-farm payrolls report, keep an eye on both the headline and revised number. The price action in the dollar indicates that the market is hoping for a stronger number. With analyst estimates relatively high, the “bigger” reaction in the currency market may be to the downside since a good number still leaves the possibility for weak job growth in August. Should non-farm payrolls surprise to the upside, a rebound in the US dollar and in the other markets may have less to do with the fact that the sub-prime has seen its worst but more to do with the market’s need for at least one piece of good news.

Kathy Lien is the Chief Currency Strategist at FXCM.