Strong economy, shifting rate risks

Key takeaways

• Last week's blowout payroll report underlined the improvement in the U.S. labor market this year, with hiring accelerating and broadening across sectors, signaling a more durable foundation for growth.
• However, despite these positive signals, markets sold off sharply in the wake of the report, as investors worry that the combination of an improving labor market and inflation risks could prompt the Fed to hike interest rates.
• Kevin Warsh will face a difficult balancing act at his first meeting as Fed chair this month, especially amid ongoing uncertainty in the Middle East. We expect the Fed to hold rates unchanged for now, looking through energy-driven inflation, unless we see signs of larger or more persistent price pressures.
• Looking past last week's knee-jerk market reaction, we think a healthier-looking labor market helps provide a supportive backdrop for corporate earnings and could encourage a broadening in market leadership beyond technology names after their strong run.
• Bonds have repriced for a “higher-for-longer” interest-rate environment, consistent with shifting risks around the U.S. economy. We think exposure to shorter maturities offers an attractive pickup over cash, while limiting exposure to rate volatility.

Don't call it a comeback

The U.S. labor market has shifted up through the gears in 2026.

Hiring, which slowed to a near standstill last year, has accelerated sharply, with last week's robust labor report putting the three-month gain in private payrolls at 166,000 - the best seen in more than three years. Over the first five months of the year the U.S. economy has created more than half a million jobs, already nearly double the 300,000 delivered over last year.

This pickup has been helped by a broadening in job creation across sectors.

Of the half million jobs created, around one-in-five has come from the goods sector, helped by hiring across construction, manufacturing and mining. Meanwhile, in services, we have seen more widespread job gains, particularly in professional services, leisure/hospitality, transport and retail. It is possible hiring ahead of the World Cup is boosting these numbers, especially in the hospitality sector. However, even accounting for this, there has been a broadening in hiring in recent months which we think should make us more confident around the durability of the improvement in the labor market.

An improving labor-market backdrop comes at a helpful time for the U.S. consumer. Incomes have been squeezed by the recent spike in energy prices, with disposable income down 4% over the past three months in annualized terms. While the effect of this on spending has been cushioned by tax cuts and lower savings, an improvement in hiring would help put household spending on a more sustainable footing.

Too much of a good thing?

Markets sold off sharply in the wake of Friday's report, despite this seemingly "good news" story, as investors fear a stronger labor market could prompt the Fed to hike interest rates. Pricing in short-term money markets is consistent with at least one 25 basis point hike (0.25%) by the end of this year, and another in 2027. 

Importantly, these concerns don't reflect the view that the economy is overheating. Despite improved hiring, the unemployment rate has held steady in recent months, and wage growth remains moderate. Payroll gains between 150,000-200,000 would over time start to eat into labor-market slack given the weak immigration backdrop, but this would take some time to materialize, in our view.

Instead, the labor market is no longer making a case for looser policy. In December last year Fed Chair Powell commented that "everyone around the table at the FOMC agrees… the labor market has softened and that there’s further risk," helping explain why most members were forecasting rate cuts in 2026. Half a million jobs later these risks have clearly not materialized, but risks to inflation have.

Hopes for a peace agreement between the U.S. and Iran late last week were again dashed, sparking some disappointment in markets. President Trump continues to signal that negotiations remain in the final stages, but messages from Iranian leadership remain more pessimistic, and we have seen outbreaks of regional skirmishes over the past week. The upshot is that the Strait of Hormuz remains closed, extending the shock to global energy markets and raising the risk of an even more pronounced inflation spike.

Against this backdrop it is little surprise to us that markets have gone from pricing multiple rate cuts at the start of the year, to potential hikes now.

A headache for the new chair

The current macroeconomic backdrop does not present the easiest debut meeting for Kevin Warsh as chair of the Fed's FOMC rate-setting committee.

We know that Warsh has made a case for lower interest rates ahead of his confirmation as chair, arguing that productivity gains driven by AI will weigh on inflation in coming years. However, rate cuts look to be off the table for the time being.

Instead, we think the big question for Warsh at the June meeting is, will he push back on the prospect of rate hikes? 

It is possible that some FOMC members forecast higher interest rates in their updated projections released at this meeting, and the committee is also likely to message that the next move in rates could be higher or lower in its press statement. Both signals could be taken as hawkish by markets.

We think Warsh will probably provide more balance, arguing that policy is in a good place at present, and effectively signaling that interest rates are on hold for the time being. The new chair could well indicate that hikes are possible if the spike in inflation is larger and more persistent than feared. However, he could also temper this message by indicating his support for rate cuts, if and when inflation cools.

This would be consistent with our view around the Fed at present. We expect the central bank to be on hold for the time being and effectively look through an oil price driven spike in inflation. We think rate hikes are possible should the inflation outlook deteriorate further, say on account of a more extended closure of the Strait of Hormuz and building domestic price pressures, but the bar for this tightening continues to look relatively high to us. 

What does this all mean for investors?

Sometimes it is important to step back from the day-to-day reactions in markets to look at the bigger picture.

The improvement in the U.S. labor market this year is good news. This sets a more solid foundation for growth and corporate earnings, in our view, especially in the face of shocks such as the recent spike in energy prices.

Therefore, we should not get too hung up on the sell-off in equity markets after payrolls, especially given the progress seen in stocks over recent weeks. Instead, we should see a stronger labor market as a supportive backdrop for equities. It is true that higher interest rates can be a headwind for markets, but we think these are less concerning when driven by improving economic fundamentals.

More practically, this backdrop could help support a broadening in market leadership. AI-related names have clearly outperformed in recent months after strong first-quarter earnings triggered renewed excitement around the sector. However, there were signs of exhaustion in these moves last week after disappointing results from Broadcom, and the Nasdaq index dropped a full 4% after Friday's payroll report.

Improving earnings growth beyond the technology sector, helped by solid economic fundamentals, could push investors to diversify away from large-cap tech names. We continue to like to hold exposure across U.S. large- and mid-cap, and international stocks too.

By contrast, we would probably push back less on the knee-jerk reaction in bond markets. While our base case is for the Fed to hold interest rates unchanged, we think markets should be pricing some risk that hikes are needed given uncertainty over the Middle East.

The good news, in our view, is that higher yields might present better income opportunities for investors, based on investors' risk tolerance, investment objectives, and time horizons. However, we do not expect bonds to rally significantly from here, and for the time being we would recommend that investors target shorter maturities, with the 2-year U.S. Treasury yield now offering a 50-basis point (0.5%) pickup over cash.

James McCann
Investment Strategy

Source for all data in commentary: Bloomberg, Federal Reserve Bank, BLS