What is NFP and how does it affect the Forex market?

NFP is the acronym for the Nonfarm Payrolls report, a compilation of data that reflects the employment situation in the United States (US). It shows the total number of paid workers, excluding those employed by farms, the federal government, private households, and nonprofit organizations.

The main figure, expressed in thousands, is an estimate of the number of new jobs added (or lost, if negative) in a given month.

But the report also includes the country’s unemployment rate, labor force participation rate (or how many people are working or actively looking for work compared to the total population), and average hourly earnings, a measure of how salaries increase or decrease from one month to another.

Why is NFP Important for Forex Markets?

The Forex (FX) market is paying extra attention to US macroeconomic numbers as they reflect the health of the world’s largest economy. Employment data is particularly relevant because of the mandate of the Federal Reserve (Fed). “The Fed’s modern statutory mandate, as described in the 1977 amendment to the Federal Reserve Act, is to promote full employment and stable prices. These objectives are commonly referred to as the dual mandate,” according to the central bank itself.

In general, solid growth in job creation coupled with a low unemployment rate is usually seen as positive for the US economy and therefore the US dollar. Conversely, fewer new jobs than expected tend to weigh on the US dollar.

The U.S. dollar index DXY, which measures the value of the U.S. dollar against a basket of six other currencies, fell sharply on Aug. 2 within an hour of the NFP release when the data came in below estimates.

However, nothing is written in stone in the forex market.

Since the Coronavirus pandemic, the dynamics of the markets have changed. The overextended lockdowns and subsequent reopenings had an unexpected effect: rising global inflation.

As prices rose rapidly, central banks had no choice but to raise interest rates, as this helps to dampen inflation. This is because high rates make it more difficult to borrow money, reducing the demand for goods and services from households and businesses and thus keeping prices down.

Interest rates hit multi-decade highs in 2022-2023 and economies cooled. But inflation took a long time to recede. In fact, most major economies are still seeing prices rise more than the central bank would like.

In the case of the US, the Fed’s objective is for prices to rise at an annual rate of about 2%. Inflation has fallen significantly but is still at 2.7%.

But what does employment have to do with the Fed?

Keeping unemployment low is also part of the Fed’s mandate, but a strong labor market usually translates into higher inflation. The Fed is in a tough balancing act: controlling inflation can mean more job losses, while a very strong economy can mean higher inflation.

Fed Chairman, Jerome Powell, hwhile he said the central bank needed a “weaker” labor market.that is, the economy creates fewer jobs, to lower interest rates.

The US economy has consistently performed very well post-pandemic, creating many jobs month after month. Even though this seems like a desirable situation for the country, the Fed has read it as a potential risk to inflation.

That’s why it decided to raise interest rates quickly and then keep them high.

If the NFP report starts to show fewer job gains, the chances that the Fed will cut interest rates increase. This is because lower interest rates mean lower borrowing costs for companies and households, reviving the economy.

On August 2, almost all leading indicators in the NFP report came in below what economists expected (red), so the market saw a weak report. After this result, investors increasingly thought that the Federal Reserve would cut interest rates aggressively.

What to expect from the August NFP report?

The July NFP report showed the US economy added 114,000 jobs, well below what economists had expected. That result sent the US dollar into a selling spiral as investors rushed to price an interest rate cut at the Fed’s September meeting. Market players were already anticipating this would happen, but speculation grew that the central bank could go with a massive 50 basis point (bps) cut in interest rates instead of the more conservative 25 basis point cut previously expected basis.

Ahead of the release of August employment data, market participants are still uncertain about the extent of the upcoming rate cut. Even more, Fed officials upped the ante on employment data when they met in July, suggesting that inflation is not as much of a concern as it once was and that the focus is shifting to how the labor market is doing.

This makes the upcoming report a critical one.

The US economy is expected to have created 160,000 new positions in the month after July’s tepid 114,000 total. The unemployment rate, meanwhile, is forecast at 4.2%, down from the previous 4.3%. Such an outcome would be understood as a stronger labor market and would cool hopes for a 50 bps rate cut. A 25 bps rate cut will still be on the table, but a more modest cut could boost the US dollar.

Results may also differ from expectations. The more significant the deviation, one way or the other, the broader the market reaction. That means, for example, if the headline read results in 150,000, the market would barely react.

However, a reading of 120,000 or even lower could fuel hopes for a wider rate cut and hit the US dollar hard. The opposite scenario also holds true, with a reading above 180,000 suggesting the labor market is too strong and may even push the chances of a rate cut beyond September, sending the US dollar sharply higher against most major rivals.