The Labor Market Is Weaker Than the Bond Market Thinks

Investors are continuing to bet that the jobs data clears the way for Fed rate hikes.

Our assessment, however, is that the labor market remains slightly weaker than normal. This should eventually cause core inflation to resume its downtrend, supporting the case for Fed rate cuts in 2027 and 2028.

Yields Climbed on Strengthening Labor Market Assessment

Since the beginning of March, the two-year US Treasury yield has climbed by around 80 basis points. Likewise, federal-funds futures have pivoted from pricing in one or more near-term rate cuts to the current expectation that the Fed will hike twice by early 2027. This rise in yields weighed on bond returns.

While at first this was spurred mainly by the oil price shock from Iran, the shift in the bond market now appears more attributable to a strengthening assessment of the real economy, particularly the labor market.

Investors may be taking their cue from recent remarks from Fed officials, who have largely dropped the discussion of “downside risks” in the labor market (oft emphasized in the fall of 2025) and now speak mainly of a labor market near full employment.

Jobs Gains Have Slowed Again

Nonfarm payroll employment experienced a spurt of fast growth in the early months of 2026, especially in the originally reported data. As of May 2026, the three-month growth rate peaked at 1.4% annualized (since downwardly revised to 1.1%), the strongest since March 2024.

But as of the July report, the three-month growth rate has fallen back to 0.2% annualized. The year-over-year growth rate stands at 0.2%, about where it’s hovered since the fourth quarter of 2025.

This tepid rate of job growth is not surprising. Productivity growth has averaged a robust 1.9% since 2020, enabling continued economic expansion without much further demand for workers. Meanwhile, the supply of workers is also constrained by the reduction in immigration.

Despite Dip in Unemployment, Labor Market Is Still Soft

The simultaneous fall in the supply and demand for workers has led to a large deceleration in the rate of job growth, while making it hard to interpret whether the labor market is strengthening or weakening.

If the drop in demand for workers is greater than the drop in supply, then we say the labor market is weakening, and slack is increasing. In such a scenario, the unemployment rate should rise.

The unemployment rate trended up for much of 2024 and 2025, playing a major role in the decision to cut the federal-funds rate by a cumulative 1.75 percentage points. In December 2025, the unemployment rate peaked at 4.5% (three-month average), up from 3.5% as of May 2023. But through July 2026, it’s dropped back to 4.2%.

With job growth having dropped back, labor market optimists’ case now mainly leans on the drop in unemployment.

However, we view the data from a different perspective.

First, the unemployment rate is still a bit elevated compared with its May 2023 nadir and relative to its 2019 prepandemic average of 3.7%.

Second, other labor market data points to a greater degree of labor market slack than indicated by the unemployment rate.

It’s been said that we’re in a “no hire, no fire” labor market. The hiring rate has hovered around 3.3% over the past year, which is much lower than normal (compare with 3.9% in 2019). But the rate of job separations is also much lower than normal, which is keeping job growth in positive territory. Separations comprise layoffs and quits. Indeed, we might just as well call it the “no hire, no quit” labor market.

Excluding the pandemic, the hiring rate is as weak as we last saw in 2013 and the quit rate as weak as in 2015.

Wage Growth Is Compatible With 2% Inflation (or Lower)

The limited opportunities for job hopping may be playing a key role in suppressing wage growth. Wage growth dipped to 3.3% year over year in July (three-month average), based on the average hourly earnings series.

Assuming productivity growth of 1.5%-2.0%, that’s consistent with inflation running at 1.3%-1.8%. Hence, we can say definitively that the labor market is not a factor keeping the Fed from achieving its 2.0% inflation target.

Indeed, the continued weakness in wage growth provides strong reason to think that inflation should resume its downward fall after the oil price shock from Iran passes, as we argue in our economic outlook.