This morning’s better than expected ADP report provided very little support to the U.S. dollar. USD/JPY spiked briefly to 105 but failed to hold its gains and the same was true for EUR/USD, which bounced off 1 month lows. The day is still early and these key levels could be retested but for USD/JPY to hit its 5 year high of 105.44, we need hawkish FOMC minutes or a solid non-farm payrolls report. While ADP has not had the best track record of forecasting NFPs, its gap with payrolls is shrinking and based on the following chart, there is still a good correlation between the two employment reports. The small increase in ADP last month suggests that payrolls could exceed 200k for the third month in a row.

This is consistent with the signal from the non-manufacturing ISM report. While service sector activity slowed in December, the employment component of the report rose to 55.8 from 52.5. This indicates that more jobs were created in the service sector last month, which bodes well for payrolls. Confidence also improved leaving jobless claims as the one major report pointing to the possibility of weaker payrolls. Barring significantly dovish FOMC minutes, the simultaneous increase in ADP and the employment component of ISM should keep the dollar supported ahead of payrolls.

How the FOMC Minutes Could Affect the Dollar

Since the beginning of the week, the U.S. dollar has been trading in a narrow range as investors wait for new direction from the Federal Reserve. The central bank began the long process of unwinding stimulus last year and while Bernanke laid out a plan for tapering, his influence will be limited to one more meeting. This makes it extremely important to understand the motivation and level of enthusiasm for last month’s reduction because it will help us determine whether the central bank will stick to his proposal for cutting bond purchases by $10 billion at each subsequent meeting.

Here’s what we know about the last monetary policy decision:

1. Janet Yellen voter to taper
2. Taper nothing more than symbolic – $10B split between Treasuries and MBS
3. Fed changes forward guidance – Low rates now appropriate “well past the time that the unemployment rate drops below 6.5%”
4. Bernanke believes FOMC will taper QE probably at each meeting, $10B each time with end of QE before 2014 year end
5. Fed says tapering will be “in further measured steps at future meetings,” determined “deliberately”, data dependent
6. Bernanke stresses highly accommodative stance, emphasizes that purchases will go on at rapid rate even after taper
7. Decision was NOT unanimous – Rosengren voted to keep asset purchases unchanged
8. Majority of Fed officials see first rate hike in 2015
9. Low inflation is a problem – “more than a bit of a concern.” Fed now sees PCE at 1.4%-1.6% in 2014
10. Fed tightens up GDP forecasts, sees faster drop in jobless rate, 6.3%-6.6% by end of 2014

If the FOMC minutes show a lot of enthusiasm for tapering with a chorus of central bankers supporting consistent reductions going forward, the dollar should rally taking USD/JPY to its 5 year high and the EUR/USD to 1.3500. However if there are widespread concerns about the high level of unemployment and low inflation with policymakers emphasizing that a predetermined course is inappropriate and future decisions should be data dependent, the dollar will resume its slide driving USD/JPY below 104 and the EUR/USD towards 1.37.

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