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The Street
The Street
Business
Martin Baccardax

Jobs report triggers key recession warning signal as stocks plunge

Wall Street is clearly moving into "careful what you wish for" territory this week as investors switch gears from pushing the Federal Reserve to lower its key lending rate to worrying about the true reason behind the now-certain September cut. 

U.S. stocks have shed more than $1.2 trillion in value over the past two trading days, turning an early-week gain that followed the Fed's July rate decision on Wednesday into one of the biggest declines of the year as investors shift focus from inflation concerns to the broader health of the world's biggest economy.

Weakening labor market data has been the key driver of that shift, which started with a muted reading of June job openings from the Labor Department that included a slowing so-called quits rate that suggested workers weren't finding new positions and raises as easily as they once were.

That was followed by weekly jobless claims, which rose to the highest in nearly a year over the period ended July 27, and data showing slowing wage gains and tepid employment costs from payroll-processing group ADP, market researcher Challenger Gray and the U.S. Labor Department.

Has Fed Chairman Jerome Powell overplayed his hand by keeping rates too high for too long? 

ANDREW CABALLERO-REYNOLDS/Getty Images

Those readings were capped off by Friday's nonfarm-payroll report, which showed a sharp slowdown in July hiring, the weakest wage gains in more than three years and a headline unemployment rate of 4.3%, the highest since October of 2021.

What in Sahm hill? 

Data from the ISM's closely tracked July reading of business activity in the manufacturing sector, meanwhile, slumped to the lowest level in eight months, with weaker-than-expected figures on new orders, hiring and near-term sentiment.

But apart from sparking the current market selloff, which has dragged the tech-focused Nasdaq index into correction territory, the motley collection of economic data has also triggered one of Wall Street's key recession alarms.

The Sahm Rule, named after the former Fed economist Claudia Sahm, essentially notes that the economy is at risk of recession when the three-month moving average of the headline unemployment rate rises by 0.5 percentage points above the lowest level of the previous 12 months.

Related: The Fed's biggest problem isn't inflation anymore

While oddly constructed, the rule itself is keenly observed on Wall Street as it "applies to the unemployment rate as reported in real-time, not the more accurate revised data that can show the economy to be in a recession months or even years after the recession started," according to Comerica Bank's chief economist Bill Adams.

And while he notes that Hurricane Beryl might have distorted some of the July weakness, and a rising Labor Force Participation Rate could signal job-market optimism, "the triggering of the Sahm rule and increase in the unemployment rate will add to concerns that the economy is weakening more than expected in the second half of 2024."

Bond market reacts harshly

That likely explains the bond market's harsh reaction to the recent string of jobs and activity data, which was well ahead of the reaction time seen in stocks. 

Benchmark 10-year Treasury note yields, which form the basis for a host of consumer-facing financial products such as car loans and mortgages, fell to the lowest levels since December by the close of the week and were last pegged at 3.831%

Bond yields move inversely to prices and generally head lower when investors are either betting on Fed rate cuts or worried about slowing GDP growth prospects. 

The former tends to lift stock prices and the latter tends to push them sharply lower, as weaker growth usually translates into slower overall sales and lower corporate profits. 

Related: Jobs report cements case for bigger Fed interest rate cut

What markets experienced this past week, however, was a combination of both.

"The economy and the stock market have been resilient because unemployment has stayed low and consumers have kept spending, said Chris Zaccarelli, chief investment officer for Independent Advisor Alliance.

"But if that is no longer the case then the Fed has made a serious error in keeping rates too high for too long," he added. "If this is a beginning of turn in the economy for the worse, then all bets are off and the Fed will need to cut rates at a much bigger magnitude and frequency then they were indicating just two days ago."

Markets move ahead of the Fed

Yung-Yu Ma, chief investment officer at BMO Wealth Management, agrees with that assessment, but also notes that on this occasion markets sniffed out weakness in the economy that the Fed normally sees first, which could also be a reason for the outsized reaction. 

"The July jobs report wasn’t actually much weaker than the June report, but the trend is now obvious in a 'club-you-over-the-head' sort of way," he said.

"The Fed is already falling behind the curve and a 50-basis-point cut in September would only be catching up" he added.

Bets on a 50-basis-point (0.5 percentage point) reduction, which were little more than a hedge just two weeks ago, surged to more than 70% last week following the July jobs report, with traders betting on more, and deeper, cuts over the final two meetings of the year.

Related: Fed drops biggest hint yet on next interest rate move

"The latest snapshot of the labor market is consistent with a slowdown, not necessarily a recession," said Jeffery Roach, chief economist for LPL Financial in Charlotte. 

"However, early warning signs suggest further weakness (and) the number of those working part time for economic reasons rose the highest since June 2021," he added. "If the labor market weakens further, markets will likely price in three cuts this year.

Recession risks ahead

But is the economy really heading into recession? After all, second-quarter growth was recently estimated at 2.8%, a much stronger-than-expected tally that was supported by business inventories (a good sign they're seeing future demand) and consumer spending (the most powerful driver of U.S. growth).

The Atlanta Fed's GDPNow forecasting tool, meanwhile, pegs the current quarter advance at 2.5%, although downward revisions are likely over the coming weeks to reflect the recent jobs and activity data. 

More Economic Analysis:

"We doubt that the economy is in recession now, given that the increase in the unemployment rate has been driven by rapid growth in the workforce and much slower — but not negative — employment growth, rather than mass layoffs," said Ian Shepherdson of Pantheon Macroeconomics.

"Nevertheless, the labor market no longer is tight, and a further rise in the unemployment rate from here would lift it materially above the Fed’s estimate of its long-term neutral rate," he added.

"We continue to think the Fed will ease by 125 basis points by the end of this year, but the first cut likely will be 50 basis points if August’s employment data are similarly weak."

Related: Veteran fund manager sees world of pain coming for stocks

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