Stock and Bond Markets May Be Surprised by the September Jobs Report in October

The U.S. stock market is eagerly awaiting the September payroll report, due on Friday, which could significantly influence market sentiment. The critical question is whether the Federal Reserve is lagging behind the curve and how the data might impact investor expectations. If employment data disappoints, could it mean bad news for the stock market?

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It's been two weeks since the Federal Reserve cut U.S. interest rates by half a percentage point, providing enough time to observe the market's response. Investors need to keep in mind a key element of market psychology—there is a growing divide between the expectations in the equity markets and those in the fixed-income markets.

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On one side, futures markets have begun to anticipate a second large rate cut at the November Federal Open Market Committee (FOMC) meeting, something typically seen only during recessions. On the other hand, the stock market has reacted positively to the Fed's shift in monetary policy, hoping that the economy is on track for a soft landing, avoiding a full-blown recession.

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During his post-FOMC press conference, Fed Chair Jerome Powell made it clear that the Fed’s focus has shifted from price stability to maximum employment, especially after the lower-than-expected inflation data from the August PCE report. This shift in focus begs the question: if the labor market worsens, will investors begin to worry that the Fed is behind the curve, leading to a potential decline in stock prices?

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So far, the market has reacted positively to the Fed's rate cut with a "risk-on" sentiment, reflected in rising stock prices. This boost is driven by a reduction in risk premiums and borrowing costs. One way to observe this effect is through leveraged buyout (LBO) candidates in the market. By screening non-financial stocks in the S&P 1500, it's possible to identify companies that investors could acquire by leveraging available cash and borrowing against their balance sheets. Since May, the number of these LBO candidates has grown from 30 to 46, despite the rise in the S&P 500. This increase is due to falling funding costs, measured by the five-year Treasury yield and the spread on junk bonds.

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However, while stock prices have risen, liquidity in the banking system has remained flat. The most recent data, gathered after the FOMC meeting, even showed a slight decline, though these figures tend to be volatile. A simple, real-time measure of liquidity can be found by looking at Bitcoin, which has seen only a marginal increase since the Fed's rate cut.

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Shifting the focus from Wall Street to Main Street, we see that banks have eased their appetite for credit, but lending activity has remained stable. It’s worth noting that liquidity data like this often lags behind real-time events, meaning the full impact may not yet be visible.

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In essence, the stock market’s optimism hinges on the hope that the Federal Reserve isn’t falling behind in managing the economy. A lot depends on how the Fed handles its maximum employment mandate. The key question is whether the labor market will stabilize or continue to weaken. Any disappointment in the upcoming jobs data could spark fears of a recession, leading to a shift in investor sentiment from bullish to bearish.

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Leading indicators of U.S. employment have been showing signs of weakness, but these indicators are starting to resemble “the boy who cried wolf,” as they've given false signals before. For example, temporary job numbers and the quits-to-layoffs ratio are typically reliable leading indicators of employment trends. Yet, despite recent softening, these indicators haven’t yet spelled out a clear warning of an impending downturn.

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Another useful gauge of labor market health is the Labor Differential Index, which tracks the gap between the percentage of survey respondents who say jobs are easy to find and those who say jobs are hard to get. This index has shown signs of deterioration in recent data, signaling potential trouble ahead for the job market.

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With stock market sentiment growing increasingly optimistic, the risk lies in this week's payroll report. A negative surprise could shift the current bullish narrative of a soft landing toward a more pessimistic outlook, where bad news on employment becomes bad news for stock prices. While some investors remain hopeful for a soft landing, there are plenty of data points that could support a more bearish view. For instance, the ratio of leading to lagging economic indicators has been dropping sharply—a pattern often seen before recessions.

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A significant divide has emerged between the fixed-income and equity markets. While the fixed-income market is anticipating another large rate cut at the next FOMC meeting—something typically seen only in recessionary periods—the stock market is embracing the possibility of a soft landing.

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As the Federal Reserve continues to prioritize its employment mandate over its price stability mandate, investor sentiment will largely depend on the strength of the labor market. With leading indicators of employment showing signs of weakening, the upcoming September payroll report could be a key turning point for market psychology. If employment data disappoints, it could shift the tone from optimism to fear, potentially signaling that the Fed is falling behind in its efforts to manage the economy effectively.

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