Rock solid US jobs report heaps pressure on the Fed, and the market

Stocks are set to end the week sharply lower after the US Non-Farm Payrolls report for September came in stronger than expected. The market was looking for 250k jobs to have been created by the US economy in September, instead the figure was 263k. While this was lower than the 315k jobs created for August, the unemployment rate unexpectedly fell to 3.5% from 3.7% in August, as the number of Americans looking for a job dropped slightly. Wage data was also scrutinised by the market, with average hourly wages rising by 0.3%, the annual jump in wages is 5%. Overall, this was a hawkish labour market report and one that supports further interest rate increases by the BOE.

Nasdaq tanks as US jobs report boosts chances of a hawkish Fed

The market is now virtually fully priced for another 75bp interest rate rise when the Fed next meets in 26 days’ time, the market is pricing in an 82% probability of interest rates rising to 3.75-4% at the next meeting. The market had been hoping for a downside surprise in the US labour market, as a drop in employment would reduce pressure on inflation in the US economy. Good news is bad news in the current environment, and today’s solid payrolls report supports the view that the Federal Reserve needs to stay the course and continue to aggressively hike interest rates. The market reaction was swift, the Nasdaq, which is highly sensitive to the future path of US interest rates fell sharply, down nearly 4% on Friday, the S&P 500 fell by nearly 3%. Every sector of the S&P 500 was lower, however, tech sold off the most, down more than 4%, while energy was the “best” performer, down by 0.72%. Healthcare and utilities, which are usually defensive stocks and perform well during periods of market turmoil, also sunk 2%. Bond yields were higher, the 2-year US Treasury yield jumped to 4.3%, while the 10-year yield was up 6 basis points, rising to 3.89%.

Interestingly, the long end of the US yield curve moved roughly in line with the 2-year yield, with the 10-year yield rising by 1 basis point more than the 2-year yield. This is worth noting. The 10-year – 2-year yield curve is deep into inversion territory, at -41 basis points, which signals a recession, however, it has been stabilising in recent sessions, even though stock market volatility is high. This tells us 2 things: 1, bond traders could be looking into the 1- 2-year future and expecting the Fed to cut interest rates because the aggressive path they are currently on is likely to cause a major recession in 2023. 2, it can also tell us not to use the yield curve in isolation, while we like to look at it to get an overview of the US economy, it is notoriously difficult to use to predict turning points in the US economy.

Unemployment is down even though the US labour force has grown in the past year

For example, the bond market may be looking towards a future where the Fed is forced to abandon its aggressive rate hiking path because it has caused a recession, yet the stock market is still reeling from the hot labour market report for September. As we mention above, this is not what was expected, and digging into the report a little further, it’s clear that the labour market remains fundamentally strong. The unemployment rate fell to 3.5% at the same time as the labour force participation rate remained steady at 62.3% last month, the employment – population ratio also remains steady. The labour force participation rate is up by 0.6% from a year ago, which also gives credence to the strength of this report. The number of people who were in part time work, but who would have preferred full time work, decreased by 306k in September. While discouraged worker numbers increased, the number of marginally attached workers in the US labour market was roughly stable.

A strong and confident US labour market

Thus, we have mentioned in the past that a Fed pivot was unlikely, given the stickiness of US core inflation and the strength in the labour market. While the trend in job creation is lower, it is still strong, anything above 200k a month is considered a strong report. Likewise annual wage growth at 5% is not acceptable to the Fed and runs the risk of creating a wage-price spiral. The risk of wages moving higher is also visible in this data. The number of job leavers has been growing in recent months, and stood at 905k last month, the number of re-entrant to the labour market was 1,840. Thus, people can leave jobs and walk into new ones in the US, most likely higher paid jobs.

Movements in the terminal rate for the Fed

Thus, even though the trend of job creation in the US is lower, this labour market is tight. Thus, the sharp decline in equities was because traders need to discount a tighter Fed funds rate, and we expect to see the terminal Fed funds rate move up on the back of this. Next week’s CPI report will also be crucial for determining where the Fed Funds rate terminates in the current hiking cycle. Post the NFP report, expectations are for the Fed’s terminal rate to remain at the 4.25-4.5% level, which is little changed. However, another measure of the terminal rate is the 5-year Treasury yield, which is currently at 4.15%, however, this yield has climbed sharply in the past week. Thus, we could see expectations of the Fed Funds rate move higher this coming week, particularly if US core inflation rises above 6.3%.