Market Brief: US payrolls disappoint, easing upward pressure on yields and the dollar

The US job creation engine decelerated sharply in September, adding to market bets on a short pause in the Federal Reserve’s tightening campaign in October. According to the Bureau of Labor Statistics, 29,000 jobs were added in the month—representing an undershoot relative to the 90,000-consensus forecast—while the previous two months were revised down by a total 60,000 positions, bringing the three-month average pace of job creation up/down to 51,000, from 71,000 ahead of the update. The unemployment rate unexpectedly ticked up to 4.2% percent from 4.1% in August, and average hourly earnings climbed just 0.1% month-over-month, slowing from the 0.3% pace set in the prior month, and rising 3% year-over-year.

The dollar is slipping and Treasury yields are down slightly across the front of the curve as traders price a more gradual series of rate hikes in the months ahead. The Canadian dollar, British pound, Japanese yen, and most other majors are advancing as rate differentials narrow and pressure on borrowing costs eases. Moves have been limited however, given that there's an asymmetry in the Fed's reaction function at this juncture: "breakeven" levels of employment are seen around the 50,000-per-month level, and inflation is of far greater concern to policymakers.

The report comes after several Fed officials suggested the central bank should pause before delivering another rate hike. Philip Jefferson, vice-chair, said yesterday “since our September meeting, yields across the term structure have increased further, a sign that investors are reassessing the evolving macroeconomic landscape. My colleagues and I will need to come to our own judgment, which may take more time”. His remarks echoed those of New York Fed president John Williams, who said earlier in the week there is “no need for urgency”. Futures markets are now placing circa-25% odds on an October move, down from 70% a week ago, with a total of three hikes priced in by the end of 2027, down from almost four on Monday.

The euro is struggling to gain even after inflation rose by more than expected last month, reinforcing expectations for at least one rate hike from the European Central Bank by December. Data from Eurostat showed headline consumer prices climbing 3.8% in the year to September, up from 3.2% in August, as oil and natural gas costs soared. Core inflation, which excludes food and energy, edged up to 2.5% from 2.4%, while services inflation rose to 3.2% from 3.0%. Isabel Schnabel, a member of the central bank's executive board, warned earlier in the week that policymakers “cannot wait” for higher energy prices to spill over into underlying inflation before acting.

The explanation for the common currency's underperformance lies in the bond market. Exacerbated by the rise in global interest rates, the spread between French and German ten-year yields has climbed to more than 150 basis points, reflecting a deteriorating fiscal outlook, compounded by political dysfunction and no apparent commitment to putting public finances on a sustainable footing.

In theory, the euro could fall to 1.10 against the dollar should Franco-German spreads widen to 200 basis points or more. But this is not the euro area's first sovereign debt crisis, nor will it be the last. Investors know the European Central Bank will step in if there are signs of contagion in other member states that threaten the transmission of monetary policy. This means that, much as in Japan, markets are now engaged in a high-stakes game of chicken with politicians and central bank officials—one that will keep the exchange rate volatile.

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