Non-farm payroll post-mortem

Friday’s blockbuster jobs report saw a sharp sell-off in the government bond markets, with 10-year US Treasuries selling off by close to 15 basis points (bps), while the 2-year US Treasuries posted a 30 bps move in the same direction, dragging gilts and German bunds with them. Risk markets held up a lot better, as the report depicted a much stronger picture for the labour market than many expected in the US, therefore increasing the chances of some sort of a soft landing. The non-farm payroll grew by 254,000 in September, the previous month was revised higher, the unemployment rate declined for a second month running to 4.1%, and average hourly earnings increased at a pace of 4.0% year-on-year (YoY) outpacing Bloomberg consensus.

In our view, this was without a doubt a strong report. Although this is just one data point in one month, it nevertheless reinforces our view that the labour market is in decent shape and not falling off a cliff, as some postulated after the July report. Chances of some sort of hard landing continue to recede which should be good for spread products. In the same way that we did not think the negative July labour market report was enough to change our views (and the Fed’s), we do not think the September report does so either. The labour market has weakened considerably from extremely tight to more normalised levels, but it is not under major stress. Companies are hiring less people than they used to, but they are not reducing their workforce. All these trends continue to be in place.

Regarding the path of monetary policy going forward and the market’s reaction to the report, we think investors have aligned their expectations more closely to those of the Fed in the last few weeks. The Fed’s base case is one where there is a soft landing, with growth moving to its potential rate of close to 2%, warranting a neutral monetary policy stance with Fed funds rate in the vicinity of 3%. If this scenario takes place, it is reasonable to assume that the curve would be upward sloping. There are various things to consider with respect to the topic of term premiums, but there is not a strong argument for saying that 10-year US Treasuries should be at 3.60% in such an environment, which is where they were trading only three weeks ago. A level closer to 4% would be more in line with history. We, therefore, tend to think that current levels are more consistent with the Fed’s base case. In fact, US Treasury markets are now pricing in two 25 bp rate cuts in November and December, in line with the median dot plot.

In the short term though, and given that the Fed remains data dependant, it would not be a surprise if upward pressure in yields continues. Markets have overreacted both ways, in more than one occasion, based on one data point so far this year, early August being the latest example. We think the more important discussion is what this labour report means for the Fed’s medium-term unemployment rate projection of 4.4% by the end of 2025. The move higher in unemployment over the last few months had led to market participants questioning this forecast. However, this latest print seems to imply that labour markets are in fact weakening mildly in the medium term, and so should comfort the market that about the Fed’s projections.

For now, we think the Fed’s views are not likely to change dramatically. It will be interesting to hear what Fed officials have to say about the print this week, but we’d wager that they will downplay the importance of one data point. We think that the probability of a 50 bp cut in the next two months is close to zero at this stage, while the two 25 bp cuts priced in by markets after the event seem reasonable. Although volatility will continue, we think it’s fair to say the curve is pricing in a more realistic scenario at this stage than a few weeks ago.