Trading the US Dollar When Economic Reports Conflict

01/07/2011 3:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

The US dollar traded sharply higher against most of the major currencies on the heels of stronger-than-expected US economic data yesterday. Near the end of last year, disappointing economic reports raised concerns about a sluggish US recovery, but the latest numbers have revived hope for those investors banking on a stronger recovery.

The ADP employment report, Challenger layoff report, and non-manufacturing ISM index all surprised to the upside, making investors more confident about the outlook for the US economy. In response, equities climbed to a two-year high, the dollar appreciated, and bond yields surged. Both the service and the manufacturing sector expanded at an accelerated pace in the month of December, putting the economy on more solid footing at the start of the year. However, in order for the dollar to sustain its gains, Friday’s non-farm payrolls report needs to meet or beat expectations.

This unfortunately is the problem at hand: Every single one of the leading indicators for non-farm payrolls that we follow except for the most important one (non-manufacturing ISM) points to stronger job growth. So the question is, which report should we believe?

ADP vs. Non-Manufacturing ISM

The new ADP employment report showed US companies adding 297,000 jobs to their payrolls in the month of December. More than 90% of those jobs were in the service sector, which is the same area of the economy that is surveyed by the non-farm payrolls report. If the service sector ISM report confirmed the improvement seen in ADP, investors would have quickly and aggressively positioned for a very strong NFP number on Friday, but unfortunately, that did not occur. Service sector activity may have expanded by its fastest pace since May 2006, but the employment component declined, which indicates that the companies in the service sector added jobs at a slower pace last month.

The ISM report has been around longer than the ADP report, and for that reason, the decline in the employment component made investors cautious about positioning too heavily for a strong non-farm payrolls release. The ADP report has done a poor job of forecasting non-farm payrolls, but directionally, it has been fairly accurate. This means that job growth last month could exceed the current forecast of 140,000, but given the decline in the employment component of ISM, payrolls will probably fall short of ADP’s 297,000 print. Although many people have criticized and mocked the accuracy of the latest ADP report, it was a blowout number that should not be completely ignored.

Here is a historical graph of employment numbers for the last few years:


Click to Enlarge

Even adjusting for seasonal factors, it will still be a strong number, and therefore, we believe that at minimum, non-farm payrolls should exceed 100,000. Layoffs also declined significantly, supporting our call for a strong NFP release. According to Challenger Gray & Christmas, planned layoffs declined 29% last month, the fewest in 13 years. Jobless claims are due for release on Friday, and the report should continue to reflect an improvement in the US labor market. With consumers spending, the US economy is improving. Strong job growth has been the missing ingredient in the US recovery, and now there's a good chance that a recovery in the labor market is finally here. The chart above shows the relationship between ADP, the ISM employment index, and private sector non-farm payrolls.

By Kathy Lien of KathyLien.com

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