US labour market data busts benign macro narrative

In describing how markets have been pricing risk in recent months, the word “complacent” has been uttered on multiple occasions. If that was your view, then Friday’s sharp risk-off move could be seen as a wake-up call, or at least evidence that investors are keenly watching for any change in the more benign macro story that has dominated recently.

While the tick up to 4.2% unemployment is not concerning in isolation, one of the assumptions of the benign macro story that has dominated in recent months has been that unemployment would only see gradual rises this year, despite history telling us labour market corrections rarely limit themselves to modest moves once the trend takes hold. With these revisions, we saw the unravelling of that story and thus a significant risk-off move as investors repriced macroeconomic risk. Any investment thesis assuming tariffs (on which the negative headlines continued to flow last week) would only have a modest impact on the labour market would also have taken a hit. The S&P 500 had its worst day since late May and the European Stoxx 600 its worst since early April. Credit markets held up better due to strong technical demand, but spreads did sell off with the widely referenced high yield Crossover index 12bp wider.

A few hours later, President Trump announced the dismissal of the head of the Bureau of Labor Statistics (BLS), Erika McEntarfer. While we are not in a position to assess McEntarfer’s capabilities, her removal creates another source of uncertainty and potential volatility for markets. For one, it adds uncertainty around the BLS’s ongoing methodology, predictions and margin for error. One argument is that President Trump was lashing out to distract from poor economic data; how might markets price any future such actions associated with negative economic statistics? It also certainly adds fuel to worries about Federal Reserve (Fed) independence, and the negative market impact of any political meddling with its functioning and credibility. From the fixed income perspective, markets that anticipate monetary policy being more permissive of building inflation would demand a higher premium on longer dated government debt. Markets that are less confident in the course of monetary policy, and facing economic data with wider error margins, would demand a higher premium to lend for longer. The likely result is steeper yield curves. While the spread between two-year and 10-year US Treasuries (USTs) is not particularly high at the moment, the difference between 10-year and 30-year USTs, now at around 60bp, is steeper than it has been in two-thirds of years since the series began in 1977. Markets are effectively pricing in more inflation tolerance and less confidence in the Fed’s guiding hand.

Overall, we would remind readers that while we’re perhaps seeing a return to volatility driven by doubts about macroeconomic stability, this uncertainty is met by solid fundamentals from credit issuers. Volatility creates tactical opportunities, but fundamentals remain key to long-term return generation. In this environment, with attractive yields relative to history on offer, we believe disciplined carry strategies remain compelling, while duration and credit risk require careful calibration.