A strong US jobs report puts the markets, the Fed, and the data at odds

Powell in a pickle.
Powell in a pickle.
Image: REUTERS/Jonathan Ernst
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Here’s a good reason to extend the July 4 celebrations for another day: The US recorded an unexpectedly strong month of jobs gains in June, with employers adding 224,000 jobs, comfortably beating expectations for about 160,000 jobs. The labor market rebounded from a weak May, when only 72,000 jobs were added, Labor Department data showed today.

There was a slight—very slight—increase in the unemployment rate, to 3.7%. (To be precise, 3.666% in June, up from 3.620% the previous month.) But this happened along with a small increase in the participation rate.

The undeniably strong report has put expectations built into financial markets at odds with the reality of US economic data. Investors are still pricing in a 25-basis-point cut in interest rates at the Federal Reserve’s rate-setting meeting at the end of this month, despite the robust jobs report.

“The markets continue to firmly expect the Fed to cut interest rates at the next meeting at the end of July. A neutral analysis of the data situation—and especially today’s employment report—hardly shows that this is absolutely necessary,” Bernd Weidensteiner, an economist at Commerzbank, wrote in a research note. “However, the Fed has already indicated that it will cut rates, the only question is the exact timing: July or September.”

Amid significant market pressure, Fed chairman Jerome Powell has opened the door for US monetary policy to go into easing mode. In mid-June, when Fed policymakers left interest rates on hold, Powell said “an ounce of prevention is worth a pound of cure.” When interest rates are near zero, as they are now, “that is a valid way to think about policy,” he said.

The urgency to impose a preventative rate cut has now dissipated. In response, traders dumped short-dated bonds and sent the yield on two-year debt surging by 11 basis points, or 0.11 percentage points, to 1.87% at the time of writing. That’s the highest in almost three weeks, returning to levels before Powell’s comments. Short-term yields are the most susceptible to movements in the Fed’s benchmark interest rates.

Today’s move in bond markets has completely wiped out any bets that the Fed would be even more aggressive and cut interest rates by 50 basis points. Yesterday, there was a 30% probability of a 50-basis-point cut this month, according CME Group’s FedWatch Tool, which calculates probabilities based on futures trading.

Nevertheless, markets are still pricing in three 25-basis-point cuts by early 2020. This may be too much. After all, since the last Fed meeting, there has been a truce in the US-China trade war. Concerns about the trade war escalating were part of the reason Powell suggested that rates could be cut. Also, July marks the 121st month since the US economy was last in recession, officially the longest expansion in US history.

“If the US labour market and, by extension, the US consumer remain in reasonable health, recession risks may start to look overpriced,” wrote Oliver Blackbourn, a money manager at Janus Henderson Investors. “We have been through this a couple of times in this cycle already and each time the US consumer, which forms the backbone of the economy, has held up.”