Non-Farm Payrolls Slash Rate Hike Odds Overnight, What Else is Needed for a Rate Cut?

TL;DR

· In July, the US nonfarm payroll decreased by 23,000, with a significant downward revision of the previous value, leading to a marked cooling of rate hike expectations for September.

· The market is divided on whether the US labor market is heading towards a recession or entering a weak balance of low hiring and firing.

· Related Assets: DXY, US Treasury Yields, Fed Rate Futures, Gold, REITs, Cryptocurrencies, US Growth Stocks.

The July employment report released by the US Bureau of Labor Statistics on August 7 reshuffled the Fed's September policy expectations. Nonfarm payrolls in July decreased by 23,000, far below the market's original expectations of an increase of 80,000 to 95,000.

More striking is the revision of previous values. May's job additions were revised down from 129,000 to 63,000, June from 57,000 to 20,000, totaling a downward revision of 103,000. After the revision, the average monthly job additions over the past three months are approximately 20,000.

The market's initial reaction was direct. US Treasury yields fell, the US dollar weakened, and rate futures were repriced. While different terminals and reporting calibers describe the probability for September somewhat inconsistently, the direction is clear: the pressure for further rate hikes has significantly diminished, with some market participants even considering the possibility of a rate cut at certain points.

This report did not immediately push the US economy into a recession narrative. While employment numbers turned negative, the unemployment rate dropped from 4.2% to 4.1%. It was more like dismantling the "Fed must continue to hike rates" narrative. Whether the pause can evolve into a rate cut will depend on confirmation from inflation and the next round of employment data.

Weakening Employment Weakens the Case for Rate Hikes

The impact of July's nonfarm payroll comes from its sudden change in the Fed's risk ranking. Previously, inflation remained above the 2% target, supply shocks such as in energy were still present, and there was internal disagreement among officials. At the FOMC meeting on July 29, the Fed voted 9 to 3 to maintain rates at 3.50% to 3.75%, with three dissenters advocating for a 25 basis point hike.

Therefore, the September meeting was not originally an easy pause point. Following the occurrence of weak employment and downward revisions, traders need to reassess policy risks. For the US economy in a high rate environment, with the three-month average job addition dropping to around 20,000, the reasons to continue hiking rates have weakened.

Federal Funds Rate Futures can be seen as the market's real-time bet on the Fed's next move. It is now conveying not "a rate cut is a certainty" but "continuing rate hikes are not as easy." This distinction is crucial for asset pricing.

Interest rate-sensitive assets are the first to react. US Treasuries and REITs usually benefit from a decline in yields, while gold, crypto assets, and growth stocks also receive short-term support when the US dollar weakens and real interest rates fall. However, this kind of rebound is mainly driven by the expectation of a policy path correction and does not necessarily indicate synchronous improvement in corporate profits, household income, or on-chain demand.

The Deconstruction of the Decline in Unemployment Rate

A decrease in employment and a drop in the unemployment rate can occur simultaneously, with the key lying in the labor force participation rate. The labor force participation rate refers to the percentage of the working-age population that is either working or actively seeking work. When this rate decreases, the unemployment rate may be artificially lowered because some individuals who have stopped job hunting are no longer counted as unemployed.

In July, the US labor force participation rate dropped to 61.4%. This means that the 4.1% unemployment rate cannot simply be interpreted as "the job market still being robust." Similarly, a single month of negative nonfarm payrolls is not sufficient evidence to conclude that "the US has entered a recession."

What needs to be observed now is whether both ends of the labor market are weakening simultaneously. On one end, there is a slowdown in hiring by companies, while on the other end, labor supply is also contracting. If both sides cool off at the same time, a non-typical situation may arise: there are few new job additions, but the unemployment rate does not spike rapidly.

This is precisely the challenge in the current pricing. The data is enough to make the market exit aggressive rate hike trades, but not sufficient to trigger a full-blown recession trade. A true recession trade usually requires a sustained increase in the unemployment rate, deteriorating incomes, and shrinking demand, rather than relying solely on a month of negative nonfarm payroll growth.

The Weak Balance Explanation Limits Recession Extrapolation

Richmond Fed President Tom Barkin previously put forward a useful framework: a low recruitment rate not immediately translating into an increase in the unemployment rate may be due to a slowdown in labor supply growth. In a speech in February of this year, he mentioned that factors such as slowing net migration and population aging would cause labor supply and demand to cool off in sync.

Using this framework to analyze the July nonfarm payrolls, what the market sees is not just "companies not hiring." It may also correspond to a weak balance of low recruitment and low layoffs: companies are cautiously expanding, but there is no large-scale downsizing yet, and labor supply is not rapidly increasing.

Another explanation comes from the productivity narrative. Some in the market believe that AI, automation, and capital investment may increase the output per employee, allowing some companies to achieve the same or even greater output with fewer people. This logic can support tech stocks and the productivity cycle hypothesis, but it is currently more suited as a long-term assumption and cannot directly prove that the July employment slump was caused by AI.

These two frameworks together limit the market's linear extrapolation of a weak nonfarm payroll report to a hard landing. Companies not hiring could be due to weakening demand or insufficient supply, automation substitution, and cost control working together. The former scenario would fuel rate cut trades, while the latter would mainly reduce the necessity of further rate hikes.

The Federal Reserve's internal divisions will not dissipate with just one jobs report. The camp prioritizing inflation will still emphasize that price pressures and supply chain disruptions have not completely abated. A weakening labor market may alter the odds of a September rate hike, but cannot substitute for evidence of inflation.

Can the Inflation Pause Turn into Rate Cuts?

The current market narrative has shifted from pricing in a September rate hike to pricing in an increased probability of a pause. There is still some distance in the data between a pause and a rate cut.

If the August CPI continues to show sticky inflation, especially if service prices and wage pressures do not ease further, the Fed may still lean hawkish. Even without a rate hike, they can suppress demand by keeping rates higher for longer. At that point, the drop in the dollar and yields may see some recovery.

If the next nonfarm payroll report remains soft, with revisions to previous data downward and inflation cooling off, a pause in rate hikes could potentially transition to a more explicit path toward rate cuts. By then, the market will need to see not only a decline in the probability of a September rate hike but also an earlier expected timing for the first rate cut, an increased cumulative size of expected rate cuts in the future, and a continued decline in short-term Treasury yields.

The key message from the July nonfarm payrolls to investors was that the certainty of a rate hike trade had been disrupted. It has not yet answered whether the U.S. is heading towards a demand slump or entering a weak equilibrium characterized by low hiring, low firing, and growth sustained by productivity gains. The next round of CPI and jobs reports will determine whether this round of risk asset rebound is merely a policy odds repositioning or has the potential to evolve into a larger-scale repricing shift.