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Labor Market Shows Signs of Slowing

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Andrew R. Michaud

• September 01, 2023

The latest U.S. jobs report for August provided a mixed bag of news for traders and Federal Reserve policy makers. While the headline number of job gains exceeded expectations at 187,000, other factors suggest that the labor market is slowing down just enough to avoid an economic contraction. As a result, the market-implied likelihood of further rate hikes in 2023 has decreased and the Treasury curve is less negative.

A Balanced Picture

Despite the strong job gains, there are offsetting factors that support the case for a slowing labor market. The unemployment rate rose slightly to 3.8% due to an increase in labor-force participation. Additionally, growth in hourly wages remained modest and job gains in previous months were revised downward by 110,000.

Market Reaction

At first, financial markets reacted positively to the data, with short-dated Treasurys rallying and the policy-sensitive 2-year yield falling. This indicated that the market believed the Fed might halt rate hikes. However, Cleveland Fed President Loretta Mester expressed concerns about inflation, tempering market expectations. Nevertheless, the Treasury yield curve continued to improve, suggesting that investors remain optimistic about the chances of avoiding an economic downturn.

Fed's Perspective

According to David Donabedian, Chief Investment Officer of Atlanta-based CIBC Private Wealth US, the combination of slower job growth, rising labor-force participation, and weaker earnings growth is ideal from the Federal Reserve's perspective. These factors make the Fed's job easier and reduce the likelihood of further rate hikes this year. Gary Pzegeo, head of fixed income at CIBC Private Wealth US, agrees that the labor market's normalization supports the belief that the Fed is done tightening.

In summary, while the August jobs report indicates a slight slowdown in the labor market, it also eases concerns about further rate hikes. The Treasury market reflects this sentiment, with investors growing more optimistic about the future of the U.S. economy.

The Yield Curve and Its Implications

The Treasury market's yield curve has been a subject of significant interest lately. On Friday morning, the 2-year yield BX:TMUBMUSD02Y saw a slight increase to 4.887%, while the 10-year yield BX:TMUBMUSD10Y experienced a notable surge of 10.5 basis points to 4.195%. These movements were accompanied by a downturn in U.S. stocks DJIA SPX COMP.

One of the key takeaways from this data is the substantial gap between the 2-year and 10-year yields. This disparity occurred as a result of the Federal Reserve's ongoing battle against inflation, marked by a series of interest rate hikes since March 2022. The fed funds rate target now stands at 5.25%-5.5%. Consequently, this has led to the 2-year yield outpacing its longer-term counterpart by around minus 69 basis points.

The significance of the 2s/10s spread cannot be underestimated, as it has historically served as a reliable indicator of potential recessions in the Treasury market. When the spread slopes upward, it signifies an optimistic economic outlook. Conversely, a negative spread indicates a more pessimistic sentiment. Recently, the spread has gradually recovered from this year's initial negativity when it reached triple-digit negative territory. Additionally, market participants are expecting the yield curve to continue normalizing as they factor in potential shifts in Federal Reserve policy.

Fed funds futures traders currently portray a high probability of no action by the Fed in September (93%), as well as a 60% or greater likelihood for the same outcome in November and December. This brings a sense of optimism to Friday's data, as Quincy Krosby, chief global strategist for LPL Financial in Charlotte, N.C. asserts that inflation will ultimately determine the Fed's rate decision.

David Russell, global head of market strategy at TradeStation, shared a similar sentiment, emphasizing the positive implications of an increasing number of individuals back in the labor force and actively searching for employment. Russell points out that the fading distortions caused by the ongoing coronavirus situation are evident in the rise in unemployment and labor force participation rates. Additionally, other indicators such as hourly wages and negative revisions suggest a softening trend, which supports an argument in favor of the Federal Reserve pausing their current actions.

In conclusion, the recent movements in the yield curve, along with broader economic factors, have garnered significant attention. While the 10-year yield surpassed the 2-year yield, market participants are cautiously optimistic as they monitor inflation and anticipate potential changes in Federal Reserve policy. As always, these indicators provide critical insight into the overall economic outlook.