Thoughts on USD, CAD & US Payrolls From Last Week

USD: The US dollar seems to be experiencing a Groundhog Day-like scenario, where the market narrative has shifted back towards recession fears based on slightly softer data. However, the market narrative appears to be out of step with the actual data. While some metrics have moved down slightly, none of them are flashing red, and the US economy added over a million jobs in Q1. This widening gap between market pricing and policymaker's task is like early February. The market is pricing the end of the Fed tightening cycle in May, which would require a fair bit of economic slowing to finish the job.

However, if things continue to stabilize, the hit to economic activity is unlikely to be as large as the FX market seems to be pricing. This is consistent with past Dollar peaks, where FX markets tend to be more range bound when there is limited economic slack. If activity declines more quickly, then the Dollar's safe-haven status makes it hard for USD to sell off too far on negative news. Overall, there is a narrow path for the market to price a large but idiosyncratic US shock, and recent trends suggest that market focus might need to start reassessing the potential size of the credit tightening in the pipeline.

CAD: Pause button still pressed. It's unlikely that Bank of Canada meeting on this week will bring any policy surprises. My expectation is that the Bank will hold steady, as Governor Macklem and the latest BoC minutes emphasized the need for "accumulation" of evidence in support of hiking. Since the last meeting, the data has not shown a significant improvement, although the labour market remains tight. The latest Business Outlook Survey had a more optimistic view of the inflation outlook and noted that labour market pressures have eased. However, the April MPR could surprise on two fronts.

First, the BOC typically revises its estimate of the neutral rate, currently at a midpoint of a 2-3% range, as well as its estimate of potential growth. Given the persistence of inflation, we could see an increase in the neutral rate estimate.

Second, with the announcement of the 2023 fiscal budget, there may be a comment on the potential impact of the budget on the Bank's future projections. Resilient growth, persistent labour market strength, and a larger fiscal deficit all pose upside risks to inflation, which could lead the BoC to resume its hiking cycle. However, tactically, it appears that the CAD is more likely to weaken until then, although the risks seem more balanced thereafter, contingent on the data flow.

US Payrolls (Mar): Steady as She Slows

For the 12th consecutive month, employment growth surprised to the upside with the economy adding 236k jobs in March. Household employment grew a strong 577k in March (+563k adjusted for the payroll concept). Despite the rise in the labour force participation rate to 62.6%, the unemployment rate ticked down from 3.6% to 3.5%.

The strong labour market trends and sticky core services inflation means, in my view, the Fed will likely hike the Fed funds rate by 25bp at the May FOMC meeting, with the June meeting remaining in play for a final 25bp rate increase.

In March, I observed that employment growth exceeded expectations for the 12th month in a row, with the economy adding 236k jobs. However, this was below my projection of 270k, and a deceleration compared to February's 326k (which was revised up from 311k). The two-month revision resulted in a subtraction of 17k jobs from the employment series.

When analysing the household survey, I found that employment grew a strong 577k in March (adjusted for the payroll concept, +563k). I noticed a large inflow into the labour force by 320k, and combined with a population increase of 160k, the labour force participation rate increased again from 62.5% in February to 62.6% (a new post-Covid high). It seems that, as in 2018-2019, the hot labour market is increasingly starting to draw in people out of retirement back into the labour force, as the prime-age participation rate remained unchanged (although the overall participation rate still remains below the pre-COVID average of 63.3%). Despite the rise in participation rate, the unemployment rate dropped from 3.6% to 3.5% in March, as the household employment went up significantly.

In March, the growth in average hourly earnings (AHE) accelerated to 0.3% m/m, which was in line with the consensus forecasts. This was an improvement from February's 0.2% growth rate. However, the year-over-year pace of AHE growth decelerated from 4.6% to 4.2%. Nevertheless, the raw wage data suggests that the pace of wage growth remains strong. The average workweek also decreased slightly from 34.5 to 34.4 hours in March.

Based on my analysis of the US labour market, I observed that job creation remains strong, with an average of +345k payrolls growth over the last three months. In February, private-sector job gains decelerated from +266k to +189k, with the goods-producing sector shedding 7k jobs and the construction sector losing 9k jobs. Private services-sector jobs growth also slowed from +255k to +196k. However, the government added 47k jobs to payrolls, following a gain of 60k in February.

The Fed is Set for Another Hike

While the pace of job growth is slowing, this seems more in line with a normalizing labour market rather than one that is rolling over and as such it still is a strong labour market. Smoothing through the last 3-6 months of data, the resulting trends point to continued labour market strength and elevated core services inflation.

The decline in 3-month and 6-month moving averages of NFP changes (allowing us to smooth through the choppiness in the Dec-Feb data) have slowed since the summer of 2022, but they seem to have stabilized above 300k (LHS chart above). This does not suggest that an imminent cooling of the labor market is forthcoming, and this cooling is necessary to slow inflation in the services sector. Consequently, momentum in core services inflation excluding housing services, is still high with core services excl. housing inflation settling down around an average that is quite a bit above the pre-COVID average (RHS chart above).

With the forthcoming release of the March CPI release likely to be still strong and banking stress stabilizing, I think that the Fed will decide to go for another 25bp rate hike at the May FOMC meeting. The strong labour market trends outlined above and continued firm momentum in core services inflation will likely keep also the June FOMC meeting in play for a 25bp rate hike, provided that financial stability concerns remain as contained as they have recently. Therefore I stick with my Fed funds rate projection of 25bp rate increases at the May and June meetings, leading to a Fed funds peak rate range of 5.25%-5.50% at the June meeting.

FX Market Implications

Finally, NFP prints near consensus expectations, but after a week of downside surprises and the aggressive repricing pricing (to cuts) in the curve this week, you get the feeling that the market came into this report hoping for something weak. The participation/unemployment rate dynamics give this report a solid tone.

Overall, the USD should see some modest firming following this report, but the scope of this move is likely to be very contained as I think it will not change the market asymmetry on policy and data (i.e. biased to cuts and more reactive to downside) in large part because of the expectation of further tightening in lending conditions post SVB. Ultimately, we are late cycle in both policy and in growth, so the market should have a natural inclination to look past strong data. Moreover, terminal rate pricing matters less for the USD now (especially post-SVB).

Indeed, the USD's correlation profile has been showing far more persistence to red/green SOFR strips, which is where cut pricing is most acute. I do not think that relationship will change anytime soon and contributes to the weak USD bias in FX markets and should keep USD bounces relatively shallow (including once the market returns from holidays). Short term, calendar spreads in STIR will see some repricing of easing expectations and that will matter for pairs like USDJPY. But I doubt there will be a wholesale view change following this number.

Positioning across FX does not look significantly stretched in the reserve currencies like EUR and JPY (though JPY is most long on my measure). As such, I think the market will look to add to longs for these pairs on dips. Elsewhere, USDCAD looks to have put in a solid base around 1.3380/00, but I think 1.3520/30 and 1.36 will be firm resistance and points where I think the market will be inclined to fade.

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