When it comes to interpreting the impact of employment data on the currency markets, conventional wisdom is pretty simple.
Higher unemployment is an indication of economic weakness, thus the currency responds accordingly. Lower unemployment means the economy is growing, and therefore the currency gets stronger.
But, if it were that easy, forex wouldn’t require so much analysis and study.
There are complications, such as when we add central bank action to the analysis. If employment goes up enough, it will indicate an overheating economy and higher inflation. This could lead the central bank to raise interest rates, further strengthening the currency. And vice versa.
The next complication to add is structural unemployment. And with so many economies in the world right now having such low unemployment, it’s an important factor that can be forgotten by traders and analysts used to nearly a decade of relatively high unemployment.
The reality of economics in a free market is that you can’t have zero unemployment. There are always companies closing units, creating redundancies with new processes and technologies. Not to mention bankruptcies, employees looking for better job prospects and people who simply can’t hold down a job.
There will always be, inevitably, a certain amount of unemployment, and that’s what’s called “structural unemployment.”
How much “structural unemployment” is varies depending on circumstances, and between economies.
There is something of a consensus among economists that a generic, advanced economy, will have a structural unemployment level somewhere between 4% and 6%. However, there are clearly exceptions; for example, Switzerland, which rarely has unemployment high enough to be in that range at all.
What the structural level is for any given economy at any given time is a matter of debate. This is a particular complication for the US, given the Fed’s mandate to keep unemployment “low.” (What exactly is “low”, since not even the members of the Fed can agree on where the structural unemployment level is?)
The academic debate aside, there are some real-world issues that are directly related to forex that concern us a lot more.
As the unemployment rate lowers to a structural level, it causes particular issues in the economy. It becomes increasingly harder for businesses to find good employees (a condition called “labor tightness”), which means they have to start raising wages without increasing production.
This directly leads to inflation and a depreciation of the value of the currency. However, it raises the cost of exports since labor costs are increasing.
If unemployment falls below the structural level, it might be that businesses simply cannot hire people to do work, because there is just no one available. This means that work goes undone, leading to less economic growth.
Conventional wisdom says that less unemployment is good, but because of structural unemployment, the law of diminishing returns applies.
The closer the economy comes to structural unemployment, the less “benefit” the currency sees from lower unemployment numbers. So much so that a drop in unemployment can be seen as bad for the currency.
If traders make a habit of expecting a bullish response to a good labor figure, they can be caught off guard.
Getting a definitive answer is slightly difficult since there isn’t much consensus on the matter. But it’s just a matter of reading the signs and using one’s best judgment.
Is it difficult for businesses to hire new workers? Is there wage inflation? Are exports increasing in price, and dropping in volume? If the answer is yes, then maybe staking out a long position in that currency isn’t a good idea.
Also, we shouldn’t forget that structural unemployment is a harbinger of a correction, if not an outright recession. Another reason for forex traders to prick up their ears when structural unemployment is the talk of the markets!