When it comes to economic data releases, there are surprises and then there are shockers. The U.S. employment report for January, which came out earlier this month, was clearly in the latter category.
The Bureau of Labor Statistics reported that 517,000 new jobs were added during January, well above the 187,000 consensus estimate, based on a Bloomberg survey of 77 economists ahead of the release. By any measure, that is a huge difference between expectations and reality.
The numbers were bolstered by mild weather, a resolution in some labor strikes and technical adjustments to seasonality factors. Still, the U.S. labor market appears more resilient than previously expected, without any clear signs of slowing—and this has implications for how the Federal Reserve will steer interest rates in the months ahead. That potential shift, in turn, could impact the outlook for a wide range of asset classes.
What’s the outlook for interest rates now? When Fed Chair Jay Powell spoke at the Economic Club of Washington a few days after the employment report, he struck a more hawkish note than at the press conference before the payroll data, emphasizing that there was "a significant road ahead" before policymakers could be comfortable with inflation returning to the 2% annual target.
Morgan Stanley’s U.S. economists now think the Fed needs more evidence of a slowing labor market before it will contemplate pausing interest rate increases. Our updated outlook for U.S. interest rates is that the Fed will hike rates 25 basis points in March and again in May, bringing the peak policy rate to between 5% and 5.25%.
Consequently, there are three key tactical changes worth flagging.
- First, where we had expected stronger future performance from U.S. Treasuries, we are now taking a neutral view. The jobs number was such an outlier that the hard data are likely too strong for the Fed to look past. As a result, investors may no longer assume that interest rates have peaked. That means rates for Treasuries may stay where they are or even move higher—and remember that rates and fixed-income security prices move in opposite directions.
- Second, in the foreign exchange markets, we expect investors to be a little more bullish about the U.S. dollar, which we had previously expected to weaken, since the strong U.S. labor market data will likely cause investors to question whether the U.S. economy is slowing relative to the rest of the world.
- Third, we are expecting stronger performance from agency mortgage-backed securities. The January employment report increases the likelihood of higher interest rate volatility, which is not great for agency MBS. Relative to other fixed-income securities, we don’t think investors are being compensated sufficiently for this and other uncertainties impacting mortgage-backed securities.
The bottom line is simply this: January’s employment report was a big surprise—big enough to cause us to rethink our expectations for the Fed and our tactical views on markets. However, it does not change our big-picture global investment outlook—which calls 2023 the year of the yield, with upside for bonds, defensive stocks and emerging markets.