Draghi's Guidance Light Is NFP Train At The End Of The Tunnel

 |  Includes: EWG, FXB, FXE, UDN, UUP
by: Ashraf Laidi

U.S. June non-farm payrolls rose by 195K, surpassing forecasts of 165K, with the unemployment rate remaining unchanged at 7.6%. You'd have to go back to 1999-2000 to find 12 consecutive monthly readings of +100K NFP. Not only non-farm payrolls have shown three consecutive monthly net additions of greater than 190K, but 12 consecutive monthly readings above 100K -- the last time this was seen was in May 1999 to May 2000. The strong U.S. jobs report means the Fed's timing for autumn tapering remains on track, implying additional yield divergence between the U.S. and eurozone/U.K. to the detriment of prolonged losses in EUR and GBP vs. USD.

U.S.-German Yield Spread at Seven-Year Highs (German-U.S. at Seven-Year Lows)

On Thursday, ECB's Draghi made the step of moving toward forward guidance, borrowed the phrase long used by the Fed in stating: "monetary policy stance will remain accommodative for as long as necessary. The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time." The decision to finally resort to forward guidance in ensuring rates remain low is the verbal equivalent of announcing outright monetary transactions, whose goal was to rein in soaring Spanish and Italian bond yields.

Draghi had little choice to contain advancing yields stemming from Bernanke's tapering comments and Portugal's political instability. Portugal's 10-year yields hit the 8.0% level for the first time in seven months, posting seven straight weekly advances -- the longest in three years. As German yields fell and U.S. yields hit two-year highs at 2.71%, the U.S.-German 10-year differential soared to seven-year highs (shown inversely in the chart below to mirror the correlation with EUR/USD).

Click to enlarge

The second half of the year started with a bang from the ECB and BoE (talking down rates), in response to the thump in the final weeks of the first half of the year from the Fed (timing of tapering).

Looking into next week (and rest of the quarter), markets will closely watch the extent of the divergence between hawkish rhetoric at the Fed (partly in function of data) and dovish stance from Draghi and Carney. If the Fed finds no reason (from the data) to remove tapering plans from autumn, then markets will witness a sharp divergence in rates between U.S. yields and U.K. and eurozone yields, leading to a the next leg down in EUR/USD and GBP/USD.

We continue to prefer EUR over GBP as EUR/GBP breaks above the four-year channel and the weak GBP becomes part and parcel of the Cameron-Osborne-Carney trio, whereas Draghi's priority remains that of lower yields. Eyeing 0.89 remains our medium-term view for EUR/GBP.

The main events to watch next week are Wednesday's release of the FOMC minutes (this will reveal comments from more hawkish members than Bernanke) and Thursday's BoJ meeting and subsequent conference from Kuroda, which will likely grease the wheels of further yen weakness ahead of the Upper House elections -- the source of Abe's power consolidation from both houses.