A very strong nonfarm payrolls – across jobs growth, unemployment, and wages – triggered a big move higher in bond yields on Friday night. The US 10-year rate blasted 14bps higher, to 2.83%, as the market moved to price an almost 80% chance of a 75bps Fed hike in September. The USD was stronger across the board, especially against the JPY, while the NZD fell back to around 0.6240. Equity markets were only modestly lower on the day, even with the repricing of Fed rate expectations. The US yield curve further inverted, pointing to a high risk of a US recession next year.
Friday night was all about a universally strong nonfarm payrolls report. The report showed much higher-than-expected jobs gains (528k vs. 250k expected), a 0.1% fall in the unemployment rate, to 3.5%, matching its lowest level in over 50 years, and stronger wage growth. Average hourly earnings increased 0.5% on the month (0.3% expected), taking the annual rate up to 5.2%. The latest data put average hourly earnings more in line with the message from the Employment Cost Index and the Atlanta Fed’s Wage Growth Tracker, suggesting wage growth is not only too high for comfort for the Fed but, if anything, wage growth appears to be picking up.
Recent market chatter of a so-called ‘Fed pivot’, which has surfaced since the last FOMC meeting, appears highly premature. Inflation (both headline and core) remains way above target, the US labour market is still going strong (for now at least) and remains extremely tight, while wage growth is running at levels much higher than what would be consistent with the Fed’s 2% inflation target.
The market reacted by significantly repricing the near-term Fed policy rate outlook. The market is now pricing an almost 80% chance of a 75bps Fed hike in September (previously 35%) while the expected peak in the cash rate has been lifted to around 3.80% (previously ~3.5%), more in line with the Fed’s most recent projections. The market still prices almost two rate cuts in 2023, although these are now expected to come slightly later in the year than previously expected. There is still a lot of water to go under the bridge before the Fed’s next meeting in September, with two CPI reports (including one this week) and another nonfarm payroll release early next month. Speaking over the weekend, Fed Governor Bowman said the upcoming data would be important in deciding how much to hike by in September, adding that another 75bps hike “should be on the table until we see inflation declining in a consistent, meaningful, and lasting way.”
US bond rates were up across the whole curve, but with the moves most pronounced at the short end, given the clear read across to the Fed’s policy rate path. The US 2-year rate was 18bps higher on the day, at 3.23%, while the 10-year rate was up 14bps, at 2.83%. This pushed the closely watched 2y10y yield curve to its most inverted level in over 20 years, at -40bps.
While the US economy notionally entered a ‘technical recession’ in the first half of the year, the US yield curve strongly suggests the risk of a real recession (one which results in broad-based job losses) lies in the future. An inverted 2y10y yield curve has historically been an excellent leading indicator of US recession. The market’s interpretation is that the Fed will need to tighten by more to cool inflation and the labour market, which inevitably increases recession risk for the economy in the medium term.
The sell-off in US Treasury bonds spilled over to offshore markets, driving a 15bps increase in the German 10-year rate, to 0.95%, and around a 20bps increase in the Australian 10-year bond future’s rate. The NZ 10-year swap rate was 4bps lower on Friday, at around 3.50%, but we should see an immediate repricing higher when trading opens this morning.
Considering the sharp repricing in Fed rate expectations, equity markets were relatively resilient. The NASDAQ was 0.5% lower while the S&P500 was down only 0.2%. The threat of more aggressive Fed action was more visible in the performance of consumer discretionary stocks, with the sector off 1.7% on Friday. The prospect of continued aggressive Fed tightening and possibly a looming recession on the horizon over the next couple of years wouldn’t typically be a good combination for equity markets. But the S&P and NASDAQ are both trading near their highest levels since May, the latter almost 20% above its recent lows.
Broad-based USD strength was the theme on Friday, unsurprising given the big upside surprise to payrolls and increase in Fed rate hike expectations. The big mover was USD/JPY, which was 1.6% higher, closing the week at 135. The EUR was down a more modest 0.6%, but still closed the week below 1.02. The NZD and AUD were both down by around 1% amidst a broadly stronger USD, the NZD ending at around 0.6240.
In Canada, the economy recorded negative employment growth for the second month in a row (-30k) but the unemployment rate remained at a record low of 4.9%, symptomatic of an extremely tight labour market. Following its super-sized 100bps hike in July, the market is pricing a better-than-even chance of a 75bps hike from the Bank of Canada next month. The CAD outperformed on the day but was still down 0.5% against the USD.
In economic data over the weekend, China recorded a record trade surplus in July, with exports up 18% from a year ago while imports were only 2% higher. The muted pace of import growth is consistent with subdued Chinese domestic demand, with the threat of new Covid restrictions continuing to linger.
The only data of any note over the next 24 hours is the RBNZ’s inflation expectations survey. 2-year ahead inflation expectations hit a more-than-30-year high of 3.29% last quarter, which isn’t that surprising given the series tends to be highly correlated with headline inflation movements. There will also be focus on the 5-year ahead inflation expectations series, which doesn’t have as much history, but which probably better represents the horizon over which the RBNZ is most concerned about.
The major focus of the week ahead is the US CPI release on Wednesday night. Headline inflation is finally set to moderate (thanks largely to lower gas prices), with the market looking for a more subdued 0.2% m/m reading, which would take the annual rate down from 9.1% to 8.7%. But core inflation is expected to remain very strong, with the market anticipating a monthly print of 0.5% m/m (6.1% y/y), clearly too high for comfort for the Fed. There are also several Fed officials scheduled to speak (Barkin, Evans, Kashkari, and Daly). Recent comments from Fed officials have tended to push back against market speculation that the hiking cycle may be almost over.
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