Labour market dents soft landing sentiment
If you were on vacation last week, your holiday blues wouldn’t have been helped when you looked at your screens this morning, given how quickly sentiment has changed, mainly on the back of one data point.
To recap, the first Friday of every month provides a labour market data dump, which often sets the tone for markets - given that it provides insights into the number of jobs being created, the average wages being paid, and the overall unemployment rate. While nonfarm payrolls were lower than expected, it was the unemployment rate that really got markets moving, coming in at 4.3%, compared to an expected reading of 4.1% and up from 3.7% at the end of January. Market commentators had already been debating whether the Federal Reserve (Fed) was in danger of falling behind the curve in cutting rates, and the sharp move higher in the jobless rate has significantly increased this speculation, with confidence of a soft landing deflating.
It's worth saying that there were potentially some one-off weather related influences on the jobs print, given hurricane Beryl (which spiked continuing claims earlier in the week). Deutsche Bank pointed out this morning that 436k were reportedly not at work due to “bad weather”, the largest July reading on record, while workers on “temporary layoff” jumped by 31% month-on-month, the largest move since the pandemic. Prime age participation rate increased again, for example, showing that strong labour supply continues to weigh on the labour data. The market is however focused on the fact that once the unemployment rate starts to move, it is historically quite difficult to stop.
This fading confidence has resulted in some very sharp moves, particularly in equity markets. The main Euro indices are down between 6-7% month-to-date (MTD), while the S&P 500 and Nasdaq indices were down almost 3% and 4.7% MTD respectively at Friday (2 Aug) close, with the futures market pointing to further aggressive falls today, while the Nikkei index in Japan is down 20% MTD – on a combination of fears of a US slow down and Yen strength versus the US dollar. Unsurprisingly, global rate markets have benefited from the flight to quality, and growing expectations of a more aggressive rate cutting cycle, with 10-year Treasuries having rallied to a yield of around 3.70%, which represents a 55 basis point (bp) move over the last ten days, while Germany bunds and UK gilts are approximately 40bps tighter. Moves in credit markets have been much more orderly than in equity markets, with high yield markets 0.5-1.5 points (pts) lower since Friday’s data, while Additional Tier 1 (AT1) markets have seen marginal widening, with the newly issued Santander AT1 bond (price on 29 July), offered approximately 50c below par.
Given that these moves seemed to have been sparked by one data point, it would be tempting to say markets are over reacting, again, and of course, there are a lot of factors at play. While just a few months ago, a lot of market participants and economists were still calling for no Fed cuts this year, there have been plenty of voices on the opposite side of that argument, saying that the rate-hiking lag had yet to be felt, and the economy was slowly weakening. In addition, the recent move upward in the unemployment rate had focused attention on the Sahm rule, which says that if the most recent three-month average unemployment rate is a half percentage point above its lowest point over the previous 12 months, the economy will go into a recession. According to economist Claudia Sahm, who set the recession indicator, this has now been triggered (technically), although she also cautioned on using only one data point and said the US is not in recession yet.
The heightening in geo-political risks over the recent days should also be kept in mind – even without the weaker data, rates would likely have seen some support.
There are also some technical factors that have driven these outsized moves; as mentioned above, there were plenty of voices in the camp supporting fewer cuts, and there was probably some scrambling to add risk-off assets, which would have contributed to the rates rally. In addition, the equity rally in particular felt very extended, with some sharp downward movements seen recently in Tech heavy indices; for example, the Nasdaq had already shed 8% of its value between its July highs and lows. We should also remember that we are in August, traditionally a month where outsized moves are reported, and when liquidity is lower due to the vacation season.
While the changes of a more aggressive rate cutting cycle has increased, and a 50bps cut in September is probably live, the US economy is still in decent shape, with corporate earnings remaining robust and GDP (Gross domestic product) growth at 2.8% (annualised quarter-on-quarter (QoQ)) as at the July reading. In addition, away from the US, the Eurozone and UK economies were reporting better growth numbers, following contractions in some areas last year.
Our base case has consistently been for a softish landing in the US, i.e. somewhere between goldilocks and a hard landing, with growth falling below potential, but not significantly so. We also thought that the path getting there could feel worse, given the confidence markets had for a perfect outcome. Behind the strong macro data, parts of the US economy have been weakening for some time, and it’s not a surprise to see this finally coming to the surface, even if it has happened quickly.
Ultimately, a softening in demand is exactly what the Fed wanted to engineer. Doing so precisely is an impossible job, but monetary policy is obviously restrictive, and the solution from here is clear. They will cut rates, aggressively if needed, although we suspect it might be less than the market is currently pricing (which is for two 50bps cuts and a 25bps cut over the next three meetings, and more than 200bps over the next 12 months). Correlations between government bonds and risk markets have turned negative, as we expected them to do so when inflation fears turned to labour market/growth fears, whilst all-in yields in credit offer strong breakeven protection, and an environment of increased volatility offers opportunities for attractive risk reward trades.
