Jobs report to signal timing and size of autumn Fed interest rate cuts

Wall Street has been waiting a long time for this, having powered through two years of relentless Federal Reserve rate hikes, sticky inflation readings and a summer market meltdown tied in part to the strength of the U.S. dollar.

The wait may finally be over, however, with Friday's August jobs report set to at last deliver the rate cut Valhalla traders and investors have been searching for since the end of the Covid pandemic.

The gap between the Fed's most-recent rate move, a quarter-point hike in July of last year and its likely quarter-point cut on Sept. 18, will be 419 days, the second-longest on record.

The S&P 500, however, has managed to rise more than 23% since the Fed's tightening cycle began in March 2022, with most of the gains were notched since the central bank's final rate hike last year, even with the chaos that roiled global markets early last month.

"August was definitely a volatile month in both directions, no doubt, and that mini flash crash ended up resulting in a great opportunity," said Ken Mahoney, chief executive at Mahoney Asset Management.

The economy's resilience to those hikes has been impressive as well, with quarterly GDP growth averaging 2.85% from the last Fed hike to the three months ended in June.

Inflation, which has remained stubbornly elevated despite the Fed's aggressive tightening, is also finally on the wane, with the central bank's preferred gauge, the PCE Price index, easing to 2.5% in July.

Labor market in keen focus

With inflation largely slain and the economy holding at a solid 2.1% growth rate heading into the final weeks of the third quarter, Wall Street's main concern has shifted to weakness in the labor market.

"Given the recent softness in the labor market, it’s not surprising that investors and the Fed have seemingly turned their focus from inflation to the labor market," said Bret Kenwell, U.S. investment analyst at eToro.

"The current investing landscape has several long-term bullish catalysts, but sustained weakness in the labor market has the potential to undo many of those positives," he added. "Investors know this, which is why they’re hoping for a reassuring jobs number on Friday."

That shift is based, however, not on worries that the Fed will start lowering rates —that prospect was largely clarified by Chairman Jerome Powell last month — but rather on the pace and scope of those cuts, should the economy start to deteriorate into the final months of the year.

Related: Fed rate cuts may not guarantee a September stock market rally

Which essentially puts Friday's nonfarm-payrolls report in the sharpest focus in months, possibly years, heading into the Fed's September meeting.

"We’re in a 'good news is good, and bad news is bad' environment, and markets are still trying to figure out if the economy is slowing too much, and whether the Fed is behind the curve," said Chris Larkin, managing director for trading and investing at E-Trade from Morgan Stanley.

Data this week haven't been particularly helpful, although on balance the figures have pointed to a labor market that looks more like it did prior to the pandemic.

Mixed summer jobs data

Job openings in the month of July fell to the lowest level since January 2021, but the so-called quits rate, which tracks those seeking new positions, rose to 2.1%, suggesting broader employment confidence.

ADP's National Employment Report showed private-sector hiring weakening, while Challenger Gray's reading of August layoffs showed a massive spike from July levels.

However, the number of Americans filing for first-time unemployment benefits fell by 5,000 over the week of Aug. 31, while unit labor costs were pegged at the lowest levels in a decade, suggesting a solid overall August jobs report with muted inflation potential from the Bureau of Labor Statistics tomorrow.

Related: How big will the Fed rate cut be? It all depends on this report

"The jobless-claims data remain consistent with a gradual increase in unemployment, rather than the sharp jump reported for July," said Ian Shepherdson of Pantheon Macroeconomics.

"Higher numbers in July and early August were largely due to Hurricane Beryl and more condensed shutdowns of auto plants for retooling than in previous years," he added. "Layoffs are still trending at a higher level than in the spring, but leading indicators signal a run of lower numbers lies ahead."

Economists are looking for the BLS to show 164,000 new jobs were created last month, up from the 114,000 tally recorded in July, with the headline unemployment rate easing to 4.2% from 4.3%.

A firmer number could test the market's forecast for a full percentage point of Fed rate hikes between now and the end of the year, while a softer print could stoke bets on an outsized September reduction of half a percentage point.

Big rate cut bets

CME Group's FedWatch tool, a real-time tracker of Fed rate trading, suggests the odds of a quarter point hike on Sept. 18 are pegged at 63%.

Bond markets are also moving in a way that suggests deeper Fed rate cuts, with benchmark 2-year notes falling to the lowest level in 2 years, at 3.719%, and 10-year notes holding at 3.753%.

"All eyes are on [Federal Fund] futures here, as we see the case for [quarter-point rate cuts] in September, November and December," said Mahoney of Mahoney Asset Management, adding that the Fed is then likely to "hold rates steady for some time and see how things go."

Related: Fed Chairman Powell signals path of interest rate cuts

LPL Financial's chief economist, Jeffrey Roach, says the August payroll report could clear the path to a big Fed rate cut.

"Friday’s payroll report could be softer than expected given the slowdown in ADP estimates," he said  "If the payroll report surprises investors and comes in weaker than expected, the likelihood of a 50 basis point cut increases."

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Bill Adams, chief economist for Comerica Bank in Dallas, says the Fed's September rate decision remains in balance.

"On the one hand, the Fed wants to prevent the slowdown of job growth from becoming a self-reinforcing decline," he said. "On the other hand, the Fed doesn’t want inflationary pressures to revive as rate cuts help credit-sensitive parts of the economy rebound."

"We see a quarter-percent rate cut at the September 18 decision as a bit likelier than a half-percent cut, but a larger cut wouldn’t be a surprise at this point," Adams added.

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