The decline in May payrolls was so severe it is statistically likely to have a lingering effect on the dollar for the next 90-days, say analysts at Bank of America Merril Lynch (BofAML)
The massive 1.8% decline in the dollar index, following the June NFP release was the largest NFP related single-day loss since 2001.
Yet the severity of the decline was unwarranted argues BofAML FX Strategist, Ian Gordon, who notes this was only the 7th worst NFP result since 2001.
He puts the outsized move lower down to Federal Reserve (Fed) officials talking up the possibility of a June rate increase in recent weeks, because they thought investors were not being optimistic enough about the US economy
"The negative surprise follows a concerted effort by Fed officials recently to “talk up” expectations for a summer hike with US data improving and the risks emanating from overseas receding. The dollar’s May rally was built largely on these two developments. The soft report weakens the argument for a near-term hike—particularly in June given its proximity to the UK’s EU Referendum—and will therefore likely keep the dollar under pressure," says Gordon.
Gordon's analysis shows weakness following a payrolls disappointment over several time periods, with on average, the dollar falling, "1.6% in the 30 days following the release of the NFP report, and 2.5% 60 days after (both including the response on NFP day)."
The analyst notes, "this suggests large shocks can have persistent effects on the USD in the months after a large negative surprise."
Gordon warns traders to consider carefully before trying to fade the dollar's relatively over sold state, due to the possibility of "persistent effects" extending weakness.
He models three scenarios which might follow on from then result:
a) The dollar actually starts to recover because the Fed dismisses then weak employment figure as an 'outlier' (ie a statistical anomaly), and chooses instead to focus on the positives in the employment report such as the continued rise in earnings of 2.5%, the fall in the participation as a result of labour market tightening and the fact 35k of the fall in payrolls was due to striking Verizon workers.
b) The dollar continues to fall as the poor payrolls number is part of a deeper recessionary trend. Gordon points to BofAML's economics department's expectations that strong employment has diverged from slowing growth and therefore was expected to 'snap-back' at some point.
c) The third scenario would see the dollar move in a range and "fail to hit new highs, due to the Fed delaying on raising interest rates, but the poor NFP not signalling a recessionary slow-down.
Unicredit still expecting two hikes in 2016
Whilst admitting that his base case scenario of a June rate rise is now almost impossible, Unicredit's Chief Economist for North America, Dr. Harm Bandholz, still clings onto his longer-term view that the Fed will hike rates twice in 2016.
"With upcoming data releases corroborating the Fed’s (and our) view that the economic recovery remains on track, and the Brexit risk off the table, we expect two rate hikes for the remainder of the year, and thus remain more bullish than financial markets."
Dr.Bandholz sees the May payroll figure as an outlier, an anomaly to be "revised away":
"While I do not want to dismiss the May employment report, I do take it with a large pinch of salt, as other labor market indicators have not shown any signs of weakness to date, while the economy has recovered nicely after taking a breather at the turn of the year. So either the May slowdown in payrolls will be revised away or we see a rebound in the following months."
Bandholz thinks markets are being too cautious, as they have priced in only one rate rise in December,and yet the economy is performing quite well overall and the Fed has arguably met several of its key targets:
"After all, the Fed is now basically meeting both of its mandates. The unemployment rate fell to 4.7% in May, the lowest since late 2007, and measures of underlying inflation rates average around 2%. In addition, wage gains have picked up, with average hourly earnings rising 2.5% yoy. What’s more, the most closely followed labor costs measures, including average hourly earnings or the Employment Cost Index, are biased downward by demographic shifts, i.e. the retiring of higher-paid baby boomers."
The Unicredit Economist says that according to the Taylor Rule which worked well at indicating interest rates based on growth and inflation in the late eighties, nineties and early twenty-first century, the fed Funds rate should be 4.0%:
"If we use the Taylor rule specification that had worked the best between 1988 and 2008, the current combination of inflation and unemployment rate would prescribe a target rate of no less than 4%! So I agree with the market that the policy path will be more cautious than it would have been in the past – just not quite as cautious as markets think."
Indeed given early indications that Chairman of the Fed Janet Yellen is striking a more optimistic tone in her speech than expected, Bandholz's analysis may be unerringly nearer to the mark.