Friday's Jobs Report Could Be The Signal The Market Has Been Waiting For

End of the summer doldrums

The summer’s calm may be set to end with a bang. Since the sharp post-Brexit recovery in late June, global stocks have been meandering in a relatively narrow range. While the S&P 500 index has been holding around all-time highs, it has also been stuck between 2150 and 2190 for the last two months. The VIX index of S&P 500 volatility, the so-called ‘fear index,’ fell to its lowest level in a year and nearly to all-time lows, a sign of market complacency and range-bound conditions.

That may all be about to change with the release on Friday of the U.S. August employment report. The non-farm payrolls report (NFP) will be a critical data point for the Fed to consider when they meet three weeks later. A solid report in line with expectations could swing the balance in favor of a September rate increase, which markets are currently not expecting.

There has been a mild shift higher in market expectations since comments from Federal Reserve Chair Janet Yellen and other Fed speakers have suggested that the September meeting could be in play. Although Fed funds futures implied probabilities of a September rate hike have risen from around 18% to 36% over the last two weeks (chart below), markets continue to favor a December rate hike over a move in September. Economists are even less inclined to expect a September hike, with only 15% forecasting a rate increase, according to current Bloomberg surveys.

Source: Bloomberg; DriveWealth

NFP and the FOMC

The August NFP report is forecast to show a +180K increase in new hires (prior +255K) and another dip in the unemployment rate to 4.8% from 4.9% in July. The ADP report of private job creation released Wednesday showed a jobs gain of +177K, suggesting a healthy NFP reading (the average NFP increase for 2016 is about +190K).

If the expected employment increase materializes, Fed policy makers may feel more comfortable moving in September, potentially laying the groundwork to achieve their April forecast of two rate hikes in 2016. Up until now, the Fed has been content to wait for clearer signs the U.S. economy is on a more sustainable path before raising rates again, as data over the last few months has been uneven. (Not to mention the Brexit shocker.)

More recent data has been encouraging, especially on the consumer front, which is the mainstay of the U.S. outlook. Just this week, personal income and spending showed healthy gains for July, and August consumer confidence hit the highest level in a year. Chicago PMI Wednesday was disappointing (51.8 vs. expected 54.0 and prior 55.8), though a late summer drop-off is not unusual. All in all, with a supportive August jobs report, the Fed could credibly make the case to hike at the September 21 meeting.

Risk Sentiment is Slipping

While stocks have remained relatively buoyant, other risk assets appear to be shifting more clearly into risk-off territory. As I suggested last week, the USD has been strong against its major counterparts on heightened Fed rate hike expectations. Commodities, as a mirror image, have stumbled in the last few weeks after failing to break above the Ichimoku cloud (blue area on chart of CRB Index below), with an impending strongly bearish crossover of the Tenkan line below the Kijun line (purple line heading for yellow line). These markets may be canaries in the coal mine for a larger reversal in overall risk sentiment.

Source: Bloomberg; DriveWealth

In stocks, signs of an important top continue to build, but the S&P 500 (shown below) and other key global indexes (MSCI World and MSCI Emerging Markets—not shown) continue to hover above their Kijun lines (yellow line), a critical source of support. Traders and investors should keep an eye on the 2170 level/Kijun line in the S&P 500, where a break below could see summer lows around 2150 challenged. A drop below there would augur still further declines.

Source: Bloomberg; DriveWealth

The timing and circumstances are in alignment for a potentially sizeable correction lower in risk assets. Markets are not expecting Fed action in September, and the August jobs report could shake that up. It’s also that time of year when investors eyes start looking to the end of the year and thoughts of profit-taking may emerge sooner than usual due to U.S. election concerns. Lastly, Friday will be a shortened day ahead of the U.S. Labor Day weekend, and liquidity could be sparse.

In terms of likely market reaction, the real signal is likely to come next week, when markets return from summer hiatuses. I can imagine a scenario in which risk assets initially rally on a solid U.S. jobs report—after all, it would suggest the U.S. economy is humming along into the end of the year. For me though, the tell-tale sign of a larger downside correction would be if initial gains in risk assets are quickly reversed. That could happen as early as Friday afternoon, but more likely in the following week.

If the U.S. August NFP number disappoints, +150K or lower, I would look for the opposite reaction, namely that risk assets (stocks and commodities) would bounce, the greenback would drop, and U.S. rate expectations would take a September hike off the table. The greater the level of disappointment, the sharper the reaction will likely be.

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