Weak ADP Data Puts Fed in a Bind

The recent data coming out of the United States regarding the labor market paints a picture of an economy that is cooling offThe implications of this trend are significant, affecting not just job seekers but also investors, policymakers, and consumersOn June 4th, the U.SBureau of Labor Statistics released the Job Openings and Labor Turnover Survey (JOLTS) report, revealing that the number of job openings had plummeted to 8.059 million in April, the lowest level since February 2021. This drop was accompanied by a revision of March’s figures, which were adjusted down from 8.488 million to 8.36 million, indicating a persistent trend of diminishing employment opportunities.

The following day, payroll processing giant ADP reported a stark increase of only 152,000 jobs in May, marking the lowest monthly addition in three months and falling considerably short of the expected 175,000. April’s job growth figures were also revised down from 192,000 to 188,000. This has garnered much attention as the ADP employment report often serves as a precursor to the more closely watched nonfarm payroll data that is set to be released, projecting an anticipated rise of 190,000 in the nonfarm employment figures while expecting the unemployment rate to remain steady at 3.9%.

Concurrently, data from the labor market has begun to support the narrative that the Federal Reserve may soon consider cutting interest rates

Swap markets have shown traders pushing the first anticipated rate cut from December to November, with some even speculating about a possible cut as early as SeptemberThe implications of this expectation have reverberated through the capital markets, leading to an uptick in U.STreasury prices and a further decline in yieldsFollowing the release of the JOLTS data, the yield on the 10-year U.STreasury bond fell nearly ten basis points, reaching levels not seen in almost three weeks.

As the Federal Reserve enters a quiet period, the fluctuations in Treasury yields are likely to dominate market movementsThe JOLTS report revealed a job openings-to-unemployment ratio that has dropped to 1.2:1, meaning that for each job seeker, there are an estimated 1.2 available positions, marking the lowest ratio since June 2021. The breakdown of specific industries showed that healthcare job openings reached a three-year low, manufacturing declined to its lowest since late 2020, and demand in sectors such as government and hospitality has also weakened.

In terms of voluntary resignations, that figure has remained stagnant at 2.2% for six consecutive months, suggesting that while there is instability in job openings, the willingness of workers to leave their jobs has not significantly changed

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The ADP employment report corroborated the notion of a cooling labor market, showing that job growth decelerated in May due to a sharp decline in manufacturingNotably, the annual wage growth has remained around 5% for the last three months, marking the lowest level since 2021, while the wage increase for job switchers has also declined to 7.8% for the second consecutive month.

“Heading into the second half of the year, employment and wage growth are slowing down,” remarked Nela Richardson, the chief economist at ADP"The labor market remains robust, but we are seeing noticeable weaknesses in sectors tied to producers and consumers, with nearly all hiring stemming from service industries.” This alleviation of labor intensity is something that Fed officials hope can continue in an effort to control demand and suppress inflation without inducing a wave of layoffs.

Insights from traders at Goldman Sachs have pointed out that the Fed’s anticipated interest rate cuts are being driven more by developments in the labor market than by a fall in inflation rates

Powell, the Fed Chair, also hinted at the possibility that unexpected deterioration in the labor market could lead to premature rate cuts.

June 7th will see the release of the official May employment report from the Department of Labor, where crucial figures about job gains and the unemployment rate will be unveiledThe current market expectation is a job increase of 190,000, with the unemployment rate holding steady at 3.9%. This anticipation has led to a focus on the Fed’s next movesRonald Temple, chief market strategist at Lazard Asset Management, remarked that "an increasing amount of evidence suggests that it may be time for the Fed to consider loosening its policies."

Controlling inflation while simultaneously stimulating employment is a balancing act that the Fed is keenly aware ofRecent economic indicators have delivered mixed signals, further muddling the outlook on whether the Fed will cut rates soon

One significant measure observed last week was the sharp revision in the first-quarter GDP and Personal Consumption Expenditures (PCE), which depicted a slowdown in U.Seconomic growth momentumAdditionally, the latest Beige Book report published by the Fed indicated that despite continued growth, there is rising uncertainty and concerns over potential risks that have darkened the economic outlook.

On the flip side, inflation is proving to remain stubbornly highThe majority of economists speculate that key inflation indicators, such as the Consumer Price Index (CPI) and core CPI, are unlikely to return to the target of 2% at least until 2026. The outlook for monetary policy is becoming more complex as new data comes inFor instance, on June 3rd, the ISM Manufacturing Purchasing Managers' Index (PMI) revealed a contraction, with a reading of 48.7 for May, not only falling short of expectations but also indicating an acceleration in the shrinkage of manufacturing activities.

Simultaneously, earlier reports indicated discrepancies with the Markit Manufacturing PMI showing a stable reading of 51.3, indicating that the manufacturing sector is still in expansion territory

However, the disparity between these reports adds to the uncertainty driving the Fed's decisionsThe anticipation of a cut in rates has seen frequent changes throughout the year, initially expected in March, then postponed to June, and now speculated for SeptemberA month prior, many traders doubted the prospects for rate cuts within the calendar year, but optimism for a year-end cut is resurfacingThe complexity of the current situation has economic observers divided.

Dan North, a senior economist at Allianz Trade, pointed out that “U.Sinterest rates have risen to a quite high level, and as a result, the labor market has also decelerated a bitHowever, on the other hand, the U.Seconomy remains relatively robust.” This duality of perspectives perhaps explains the Fed's current inertia in making policy decisions.

The Fed's next rates decision will take place from June 11-12, with experts expecting no immediate changes based on the guidance from Fed officials

The prevailing sentiment among economists indicates limited expectations for a rate cut at the upcoming July meeting, with only a 14% probability projected by derivatives traders, while the odds for a September cut hover just above 50%.

Further polling indicates that among economists surveyed, the consensus leans toward September being the month for the first rate cut, with some positing that a solitary cut might occur or none at allMeanwhile, U.STreasury estimates have been impacted by these evolving market sentimentsPowell’s past statements about inflation have indicated skepticism regarding its decline, pushing for sustained monetary policy strength, showcasing a hawkish inclination.

This hawkish stance is reflected in the rising yields on U.STreasuriesRecent analysis from Wellington Management has highlighted that due to inflation data exceeding expectations, market estimates of the number of interest rate cuts by the Fed in 2024 have significantly dwindled from six to merely one or two

The yield on the 10-year U.STreasury bond has surged more than 80 basis points since early this year, contributing to an overall decline in bond market valuations.

This surge in Treasury yields has, at times, sparked a sell-off in risk assetsThe nervousness in the markets has extended beyond U.Sgovernment debt, leading to widespread pressure among global sovereign bondsAuction results for U.STreasuries have been tepid, reflecting waning demand, not only for long-dated bonds but also across shorter durations.

Market participants view this scenario as a reflection of concerns surrounding U.Sdebt levels and a lag in anticipated rate cuts, with continued high interest rates impacting the cost of borrowing for the federal government while placing short-term bond investments at riskFollowing the ADP report on June 5th, U.STreasury yield trends reflected an ongoing climate of lowered expectations for rate reductions, with the benchmark 10-year yield dropping 3.89 basis points to 4.2871%, while the two-year yield also saw a decline.

Historically, rate cuts generally heighten the appeal of bonds as prices rise in such an environment

However, fears around the Fed acting to suppress a struggling economy could pose challenges for Treasuries as they typically reflect future expectationsGiven this context, the question arises: is investing in U.Sgovernment bonds still a worthy endeavor?

“While the Fed's decision to hold off on cuts for an extended period might disappoint some in the market, it does not inherently negate the rationale for bond investment,” said Wellington ManagementTheir analysis alluded to historical instances during the Fed’s tightening cycle from 2004 to 2006, where despite delays in rate reductions, bonds outperformed cash in several time frames during the years that followed the last increase.

“Investors should still contemplate reallocating cash towards bondsHistorical precedents exist for a long-standing Fed stance