The all-important US Nonfarm Payrolls report will be released this Friday. Investors will, as always, look for signs of where the US economy may be headed. With recent figures pointing at a sustainable (in the loosest sense of the word) recovery for the US, many will want to see some type of confirmation from the payrolls numbers to validate the optimism.

Yes, employment has been one of a few drags on recovery expectations; the other biggie that stands out is the still pathetic real estate market. And there is debate over whether or not the municipal bond market in the US has the potential to create a eurozone style debt mess; but for now this topic has gone cold. The welcomed news, however, comes in the form of manufacturing.

Chinese and Indian manufacturing began making upward strides several months ago and has helped keep risk appetite supported as things began improving in the industrialized world. German numbers then followed suit. And now we have improvements in the US and the eurozone as a whole. Yesterday the UK manufacturing numbers blew expectations out of the water, with PMI rising to 62 versus the expected 57.9. The eurozone also beat expectations, 57.3 versus 56.9 [Germany alone saw their PMI hit 60.5 versus the expected 60.2.]

The British pound as reacted accordingly to the good news…surging to a fresh high against the dollar yesterday…seems like a week ago traders, including us, were thinking UK stagflation and how nasty that would be for the pound. Things change quickly in this market, indeed!

Click on image to enlarge!

Then the US numbers for the month of January were released and also blew expectations out of the water, 60.8 versus 58.0. The US dollar is very slowly scraping back some of its losses in the wake of the US PMI release. There is potential this creates a US-asset bid that has the stock market sustaining its climb while the US dollar firms up.

The US dollar is honing in on key weekly support. Little in the way of yield support at the moment, but Egypt is fluid; the middle-east in general is in play, and China’s seriousness on inflation all loom as potential dollar risk bid material.

Click on image to enlarge!

We know very much that expectations over growth and yield differential are clearly the main drivers [These are always the main drivers, but often times they sit off in the background and give way to more superficial ideas.] Traders are very likely to position around the US Nonfarm Payrolls report looking for an improving US growth differential between the US and its across-the-pond counterparts. That is what would impact current trends. But this would merely be kneejerk. As was explained yesterday in CCPRO and today in the special audio/visual chart analysis, the US dollar needs some yield support. That means the Fed must start feeling hawkish ... or at least start pretending a strong dollar is important to them, which is clearly not the case right now.

For now, the global economy seems to be toughing it out. Companies are digging deep and there is something to show for it. That something could certainly be cause for debate, as better-than-expected manufacturing numbers in the developed world could be aberrations and numbers coming out of the most important emerging markets could soften up if inflation provokes official action to stem overheating and bring down growth. E.G. This from the top of CCPRO on Monday:

China: the masters of reverse psychology? We, among others, cite the 8% GDP growth threshold as the difference between a stable China and social unrest. A drop from 10% to 8% may not look like much but it would mean a lot for the Chinese commoner and a stable society. But now a former Chinese central bank advisor is announcing a Chinese GDP target of slightly below 8% for the next five years, according to a Down Jones report. Is there any reason the Chinese would intentionally bring their economy down through that highly recognized and highly important 8% level? No. But saying so gives them the leverage to say a growth slowdown was deliberate and controllable ... even if Chinese officials actually fear a slowdown of that extent and possess little control over it.

Jeremy Grantham recently laid out his market views. While his commentary was clear-headed and self-congratulating at the same time, he noted one area in particular where he was surprised; it caused him to mis-forecast the extent of the risk appetite rally in 2010:

On one part of the fundamentals we were, in contrast, completely wrong. On the topic of potential problems, I wrote, “Not the least of these will be downward pressure on profit margins that for 20 years had benefited from rising asset prices sneaking through into margins.” Why I was so wrong, I cannot say, because I still don’t understand how the U.S. could have massive numbers of unused labor and industrial capacity yet still have peak profit margins. This has never happened before.

For historical perspective, look where the recent recovery has left us on a measure of capacity utilization:

Click on image to enlarge!

Just now we are passing up the recessionary trough of 2000-2001. But it should be noted that the changing landscape of US industry has something to do with the lower peaks in this data. So then maybe it makes more sense to look at percent change, rather than absolute values:

Click on image to enlarge!

That’s quite a turnaround in the year from June 2009 to June 2010. Not since the mid-70s has there been a comparable move. Companies have found ways to become more efficient. And they are realizing it through rising profit margins. But then there is joblessness.

Click on image to enlarge!

We are holding above 9.5% unemployment while companies are finding ways to squeeze out profits from a subpar economy and investors are finding ways to squeeze out gains from above-par corporate profits. Are markets already priced for perfection? If so, it could get ugly here soon without some improvement in unemployment and its follow-up effects on consumer demand and general economic activity.

Or are markets fairly reflecting the growth environment in the US? I know at least a few people who think stocks in particular are overvalued.

Here’s to Friday!

For more from Jack, visit Black Swan Capital and register for their daily newsletter, Currency Currents.