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Market Extra: Robust U.S. jobs market adds to worry over how much higher interest rates need to go

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November’s better-than-expected U.S. job gains brought a touch more anxiety to financial markets on Friday, as investors reacted to the possibility that interest rates may need to go up even more next year than previously thought.

Traders boosted the likelihood that the fed-funds rate will get to 5% or higher by March to almost 40% at one point, up from roughly 31% on Thursday. JPMorgan Chase & Co.’s Michael Feroli saw an increased chance that the Fed’s median rate forecast for 2023 goes slightly above 5%. And at Stifel, Nicolaus & Co., analysts said that even 7% — an upper-bound estimate cited last month by St. Louis Fed President James Bullard — may be understating how much higher borrowing costs need to go.

The U.S.’s 263,000 new job gains for last month, which exceeded economists’ expectations for a 200,000 gain, were the type of numbers usually associated with an economy running at above-trend growth — not one that’s endured six rate hikes since March, with a seventh likely on the way in less than two weeks. Average hourly earnings also jumped sharply in November, triggering worry that the Fed’s attempts to curb inflation aren’t having enough of an impact just yet.

Read: U.S. jobs data puts jumbo interest rate hike back on table at Fed’s December meeting

“The latest data signals that the labor market is still very tight, beyond what the Fed would like to see, and significantly tighter than what most policy makers would have expected after 375 basis points of rate increases,” said Lindsey Piegza, chief economist for Stifel, Nicolaus in Chicago. “This morning’s data, coupled with the increase in wage pressures, reinforces the need for the Fed to remain vigilant. Now is not the time for the Fed to question its resolve or give the market reason to question its resolve.”

Via phone on Friday, Piegza said, “I don’t think we are going to have to push to 7% or above with rates, but it’s on the table if inflation continues to surprise to the upside or international pressures ignite a new round of inflation. This notion that inflation has nowhere to go but down is not where we are quite yet.”

Piegza isn’t alone. Economists at BofA Securities see risks tilting to the upside on their view of a 5%-5.25% terminal fed-funds rate by March, or a level at which the Federal Reserve is likely to stop hiking rates. Meanwhile, Steven Blitz of TS Lombard said any decision by policy makers to slow the pace of hikes to a half-percentage point from another three-quarters-of-a-point increment would be “a mistake,” and Fed officials are “making it more difficult on themselves” if they take the latter option off the table.

“In sum, the Fed is far from done — 75 is on the table for the December meeting, although given all the communication around slowing to 50 it will be hard for them to back away at this point,” Blitz wrote in a note, adding a higher terminal rate may be necessary.

“The reason begins with the labor supply/demand mismatch,” he said. “Unlike other Covid-related supply problems, this one cannot fix itself.”

Financial markets reacted sharply to Friday’s jobs report as investors readjusted their expectations for rates, inflation, and the labor market. All three major stock indexes were lower for much of the New York session, though Dow industrials
DJIA,
+0.19%

flipped to positive in the final hour of trading. The policy-sensitive two-year Treasury yield
TMUBMUSD02Y,
4.300%

soared to around 4.3%.

Stock Market Today: Live coverage of Monday’s market action

With the fed-funds rate target already between 3.75% and 4% and likely to move to at least 4.25%-4.5% at the Fed’s Dec. 13-14 meeting, what’s evolving is “a more complicated scenario than most people anticipated,” said Piegza of Stifel, Nicolaus. “Covid has interrupted most relationships in the economy, whether it’s labor-force  participation, consumer spending, manufacturing, all of these different variables.”

“Rate hikes may not have the same impact as they had before,” she said. “The Fed can’t fix price pressures on the supply side. It can have an impact on the labor market, but the level of that impact could be reduced. It’s certainly going to be uncomfortable for markets and we are likely to see ongoing volatility.”

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