Tonight, will the US non-farm payrolls "add fuel" to rate cut expectations?

The U.S. job market may cool down in July as the economy gradually slows, with Hurricane Beryl expected to weaken employment momentum. However, even if the U.S. Department of Labor's July non-farm payroll report to be released later on Friday does show a weakening employment situation, it is expected that this slowdown will be gradual and in line with the moderate slowdown the Federal Reserve hopes to achieve.

Mike Reynolds, Vice President of Investment Strategy at Glenmede, responsible for investment strategy, said: "If the Federal Reserve intends to achieve a soft landing, then this is likely what it will look like. What you see is that the labor market is only moderately soft at the margin, unlikely to spiral out of control and enter a negative feedback loop."

In fact, according to a general estimate by Dow Jones, the U.S. July non-farm payroll report is expected to show that the number of non-farm payrolls in July will increase by 185,000, lower than June's 206,000, and the unemployment rate will remain at 4.1%. Over the past year and a half, employment reports have often exceeded market expectations. However, some economists believe that this report may be even weaker. Goldman Sachs expects that Hurricane Beryl, which ravaged much of Texas (especially Houston), will reduce 15,000 jobs; the bank believes that total employment growth will be closer to 165,000. Citigroup's forecast is even lower - an additional 150,000 jobs and a slight increase in the unemployment rate to 4.2%.

Focus on the Unemployment Rate

If the unemployment rate continues to rise, there may be concerns about the so-called "Sahm Rule" being triggered, which has had a perfect record over the past half century. This rule undoubtedly points out that when the three-month average unemployment rate is 0.5 percentage points higher than the 12-month low, the economy is in a recession. A year ago, the unemployment rate was 3.5% before it started to rise. This economic recession indicator was developed by Federal Reserve economist Claudia Sahm.

Federal Reserve Chairman Powell was asked about the so-called "Sahm Rule" at a press conference this week, and he said policymakers "believe that what we are seeing is the normalization of the labor market," but if "signs begin to show more than that, then we are prepared to respond."

A more moderate explanation for the recent rise in the unemployment rate is that strict immigration restrictions and millions of Americans leaving the labor market during the pandemic artificially depressed the unemployment rate. Since then, with the reversal of these trends, the labor force participation rate has rebounded, meaning that the unemployment rate is falling back to levels that would have been dominant.

Last week, Sahm herself said that the surge in labor market entrants "may have exaggerated" the extent of labor market weakness, arguing in a communication on July 26 that "the Sahm Rule is currently sending the correct warning signals about a cooling labor market, but the volume is too loud."

Other traditional warning indicators, such as temporary employment and quit rates, have also been issuing warning signals. However, many forecasters believe that there is reason to interpret the recent deterioration of these indicators as a cooling off of the hot job market that came with the pandemic recovery, as the economy returns to normal. Michael Reid, a U.S. economist at Royal Bank of Canada Capital Markets, said, "This is not a traditional business cycle. In this cycle, we are emerging from a very different environment. The speed of change may be quite deceptive just because you get the whiplash effect from the pandemic - up and down."

The situation with other indicators is similar, such as job vacancies, which have dropped by nearly a third since reaching a peak of 12.2 million two years ago. Despite the astonishing speed of the change in vacancies, reaching 8.2 million, it is still significantly higher than pre-pandemic levels. The same goes for initial jobless claims, which, despite a recent uptick, remain at historically low levels.

Powell said this week, "In this era of the pandemic, many obvious rules have been overturned. A lot of conventional wisdom doesn't work because the situation is really unusual."

Fed remains optimistic about the job market

In the first half of 2024, nonfarm payrolls increased by an average of 203,000 jobs per month, with more workers entering the labor market, causing the unemployment rate to rise, reaching the highest level for those considered unemployed but actively seeking work or temporarily laid off since October 2021. Fed Chairman Powell pointed out on Wednesday that the previous supply-demand gap in the labor market is close to being balanced. Currently, the ratio of job openings to available workers is only 1.2 to 1, compared to 2 to 1 a few years ago as inflation intensified.

Job vacancy data indicates that as the economy rapidly recovers from the initial shock of the pandemic, workers have lost the rare advantage they had in recent years. Job seekers now take longer to find a new job, and wage growth has almost returned to pre-pandemic levels.

Sarah House, senior economist at Wells Fargo, said, "Regardless of whether we have crossed the threshold of a recession, we are seeing a real cooling off in the labor market. The current trend is not favorable."

If these factors continue to balance out and other inflation indicators show progress, Powell strongly hinted at a rate cut in September. He said at a press conference after this week's Fed policy meeting, "Our confidence is growing as we are getting good data. Frankly, the weakness in the labor market conditions makes you more confident that the economy is not overheating." The market will focus on Friday's data to confirm whether Powell's view on the labor market is accurate, and whether the Fed is too confident or waiting too long to start cutting interest rates. More and more on Wall Street are calling for the Fed to start easing monetary policy, as most indicators show that the inflation rate is only a short distance away from the Fed's 2% target.

For example, in recent weeks, some prominent economists including former Fed Vice Chairman Alan Blinder, Goldman Sachs Chief Economist Jan Hatzius, and former New York Fed President William Dudley have advocated for an early rate cut, partly due to the latest developments in the job market. Currently, it is widely expected that the Fed will begin easing monetary policy in September.

DoubleLine Capital CEO Jeffrey Gundlach said on Wednesday that he believes the U.S. economy is already on the brink of a recession. Gundlach said, "When we look back today... I'm a little bit believing that we will say we are in a recession in September 2024."

Wage growth is also a key factor

The Fed voted at the meeting to keep the benchmark federal funds rate unchanged in the range of 5.25% to 5.5%, which has been maintained at this level for the past year. After this news came out, the market rebounded, but after news of an increase in initial jobless claims and further contraction in manufacturing at the beginning of last week, the market gave back its gains on Thursday. Nick Bunker, North American Economic Research Director at Indeed Hiring Lab, said: "The FOMC is betting that the labor market is strong enough to wait until autumn to confirm that inflation will return to 2%. Hopefully, it will pay off."

As always, the market will also focus on the average hourly wage section of the report to look for signs of potential inflation. Economists predict that wages will increase by 0.3% month-on-month and 3.7% year-on-year in July. If this data is correct, the year-on-year growth rate will be the lowest income growth since May 2021.

BeiChen Lin, an investment strategist at Russell Investments, said: "Even if this report shows that wage pressures unexpectedly remain 'stagnant' or slightly re-accelerate, we believe that the progress the Fed has made in inflation so far means that as long as subsequent data (such as July CPI) aligns, the Fed should still have the opportunity to cut rates in September." ”