A Labour Market Losing Momentum

Today's US employment report changed the market conversation in a matter of minutes. Nonfarm payrolls fell by 23,000 in July, against expectations for an increase of around 80,000. Just as importantly, June's gain was revised down from 57,000 to only 20,000, while revisions to May and June removed 103,000 jobs from earlier estimates. This was not simply a disappointing headline number. It was evidence that the labour market has been weaker than previously reported.

At first glance, the fall in the unemployment rate from 4.2% to 4.1% looks reassuring. The detail is less comforting. Labour force participation slipped to 61.4%, meaning fewer people were counted as participating in the workforce. That decline helped push the unemployment rate lower and makes the improvement less impressive than the headline suggests. Wage growth also cooled, with average hourly earnings rising just 0.1% during July and 3.2% over the year.

Put together, the report paints a picture of a labour market that is cooling more quickly than investors expected. It is not yet screaming recession. The economy still has areas of strength and layoffs remain relatively contained. But negative payroll growth, substantial downward revisions and softer wage pressure make it much harder to argue that employment conditions remain comfortably strong.

Why Markets Liked the Bad News

Markets reacted quickly because the report changed expectations for Federal Reserve policy. Before the release, investors saw a September rate increase as a genuine possibility. Immediately afterwards, pricing for a hike fell sharply. Data showed the probability dropping to 44% from 54.7%.

The bond market delivered the clearest message. The two year Treasury yield fell towards 4.16%, while the 10 year yield moved towards 4.60%. The sharp move at the short end is particularly telling because the two year yield is highly sensitive to expectations for Fed policy. Investors were effectively saying that a weaker labour market makes another near term rate increase less likely.

Equity futures liked that message. S&P 500 futures rose around 0.5% after the report, while Nasdaq 100 futures gained more than 1%. Technology shares were also supported by strong company specific earnings, so the rally cannot be attributed to rates alone. Even so, the relative strength of growth stocks is consistent with falling yields providing valuation support. Lower discount rates increase the present value of future cash flows, which matters particularly for companies whose expected profits lie further into the future.

Gold offered another piece of the puzzle. It had already been rallying before payrolls were released, helped by lower inflation concerns, geopolitical uncertainty and expectations that US tightening might be nearing its limit. The weak jobs report added another supportive impulse. Treasury yields fell and the dollar weakened, reducing the opportunity cost of holding a non-yielding asset such as gold.

The Market Is Walking a Fine Line

This is a familiar bad news is good news environment. Investors are willing to welcome weaker economic data because the benefit of less restrictive monetary policy currently appears greater than the damage caused by softer growth. In simple terms, markets seem more worried about another Fed hike than about a modest slowdown in the economy.

That balance, however, is fragile. Weak economic news is only good for equities while investors believe growth is slowing rather than collapsing. If negative payrolls become persistent, unemployment starts rising materially or companies begin cutting workers aggressively, falling yields could take on a very different meaning. Instead of signalling relief from monetary tightening, they could begin signalling recession. At that point, investors would probably focus less on lower discount rates and more on weaker revenue, falling earnings estimates and wider risk premiums.

There are encouraging elements in today's reaction. Equity futures rose rather than fell, technology led the advance and corporate earnings remain supportive. That suggests investors are not yet treating the jobs report as evidence of an approaching recession. Falling oil prices could also help if sustained, because lower energy costs would ease inflation pressure and give the Fed more room to tolerate weaker employment.

The key point is that today's rally does not deny the weakness in employment. It shows how asset prices remain tied to policy expectations. The next test is inflation. A soft labour market does not automatically guarantee easier monetary policy when inflation remains above the Fed's target. If upcoming inflation data remain uncomfortably strong, policymakers could still hesitate to declare victory.

For now, though, today's market moves tell a coherent story. Investors have decided that weaker employment reduces the threat of another rate hike more than it increases the threat to corporate earnings. That is why Treasury yields fell, the dollar weakened, equity futures rose and gold strengthened. Bad news is good news again, but only while the slowdown remains gentle enough for profits to survive it.